ING Direct’s recent survey results about retirement are scary. I don’t know what the world is going to be like in thirty years, the time I’ll be approaching “retirement age.” I do know that if my pattern of increasing expenses doesn’t change until then, and if I’m still earning primary income by trading my time and effort, a comfortable retirement is going to require a lot of saved and invested money.

If you believe the 4% safe withdrawal estimate, in order to live off the equivalent of today’s $50,000 a year, I’m going to need the equivalent of today’s $1,250,000 invested. Assume a modest 3% rate of inflation and I’ll need more than $3,000,000 in 2040 dollars. Unless I make major reductive changes to my lifestyle or move somewhere in the world where the cost of living is low, I’d prefer to live on more than today’s $50,000 a year. I’m going to need a bigger nest egg.

Although it sounds sophisticated, this is speculation based on assumptions that could be very wrong. I’m doing exactly what 53% of working Americans are doing according to the ING Direct survey: guessing the amount of money I’ll need to save for retirement. Even if I were to use an online retirement calculator sponsored or designed by banks, investment companies, or bloggers, my results would still be guesses, though most likely slightly more accurate.

ING Direct is offering a planning tool that takes into account the lifestyle you’d like in retirement, your investment style, and your assets and planned contributions, and presents a savings plan. According to my results, I am surprisingly on target for over $3,000,000 in 2040. This includes a number of significant assumptions about my future income and rate of return on stocks.

According to the ING Direct survey, one third of Americans age 55 and over think their number is $250,000 or less. There is a subtle implication that this won’t be enough for many retirees.

In reality, I don’t know what my retirement will look like in 30 years. I may never be able to stop working in order to afford expenses for my future family. The best we can do is set a target that makes sense for what we know and understand of the world today, and make choices based on the assumption that the nature of money and finance won’t change too much between now and then.

What is your retirement number?

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I Might Need $3,000,000 To Retire: What’s Your Number?

Overconfidence leads investors to believe they can make buying and selling decisions that would result in their performance beating the indexes. Most professional fund managers don’t beat the indexes on a consistent basis, so there is little reason to believe that amateur stock-pickers will be able to succeed where professionals have failed.

Are you overconfident? Kiplinger offers a questionnaire to help you determine whether you are more sure of your thoughts than perhaps you should be. Take the quiz here. The questions are not all related to finances, but are designed to measure your level of confidence overall. If you’re like me, the ranges you selected for the answers you didn’t know where too shallow.

Once you’ve had a chance to evaluate your results, take this second quiz and see if you can change your score.

Although overconfidence helps you accomplish your goals in life, it can damage your finances by leading to believe you’re a savvier investor than you are. So here are four ways to settle down and accept reality.

1. Invest mostly in index funds. Professionals can’t beat the indexes consistently, so it’s unlikely you will be able to either. Investing in index funds does not guarantee “average” returns, it will result in your investments performing better than actively-managed funds.

2. Invest regularly in equal amounts. You can’t time the market. I tried this recently, buying shares in Toyota Motors after one announcement of additional recalls. My belief is that Toyota will eventually recover, so I’ll hold on to this for some time. But if my goal were to make money quickly, I would have failed. More bad news propelled the stock price lower.

Dollar-cost averaging into the stock market, purchasing the same amount of an index fund at regular intervals, takes the human tendency to fail at decision making out of the process.

3. Don’t invest in the company you work for. It’s hard to have an objective opinion about your employer. Your too close to the situation. Also, executives will often say what is necessary to boost the confidence of their employees while not addressing potential problems. You are already invested in your company due to the salary and benefits you receive.

You may be required to invest in your company’s stock through a retirement plan, but you should sell these investments and buy index funds as soon as possible. My actions should serve as an example of what not to do. I invest 10% of my salary in company stock at a 15% discount through my company’s stock purchase plan, but I’ve been reluctant to sell while the stock has declined.

4. Eliminate or reduce emotions when making financial decisions. Emotions can’t simply be turned off. They’re essential for our brains to function. Nevertheless, separating emotions from money as much as possible will offer better financial results than reacting to your emotions.

A study in 1986 (McCormick, Walkey and Green) revealed that 80% of the survey respondents consider themselves better drivers than average, so it is not surprising we overestimate our financial abilities as well. No one wants to hear they’re not better than average, however. This overconfidence allows us to break out of our comfort zone but can be damaging to finance if allowed to rule decisions with money.

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You’re Not That Great: 4 Ways to Combat Overconfidence

This past weekend, a sculpture by Alberto Giacometti broke the previous record for most expensive piece of art sold at auction. An anonymous bidder purchased “L’Homme Qui Marche I” for $104.3 million, up to five times more than the expected price. This may be a good sign for the art world in need of a recovery from a bubble and crash. Only a few months ago, Lehman Brothers was selling off art within the company’s possession at any price possible in order to pay back their creditors.

The winner of the auction is remaining anonymous, and that’s probably a good idea. Many owners of high-priced art are investment banks. Consumers are still angry about taxpayer money used for bailouts and executive bonuses, so from a public relations perspective, no one would want to be seen spending this much money on one piece of art. In addition, storage, security, and insurance for this valuable sculpture is sure to be a significant expense, as well.

However, well-chosen art could provide to be an excellent investment. There are drawbacks. With the expenses mentioned, art as an investment is cash flow negative. Unless you are able to lend the works to a gallery, they will not produce income for the owner. The only chance to come out ahead is to sell the art for a higher price than the purchase price, and this is a very risky proposition. Art prices fluctuate and tastes change.

While small-time investors may be used to transaction fees no larger than $10 a trade, the art market isn’t as modest. Not only does the selling price need to be higher, but exorbitant transaction fees must be factored in. Even if you sell a work of art for 20% more than you paid for it, everyone involved in the sale, from the auction house to the banks that facilitate the purchase will find a way to eat into your profit margin.

From one perspective, $104.3 million seems to be a large amount to spend on a work of art when people are suffering throughout the world. The money could save lives. But art is an essential component of culture, and if this purchase broadens awareness and appreciation, the world may be better off.

Do you feel a work of art is a good choice for spending $104.3 million right now?

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Breaking an Art Sale Record With $104.3 Million for Running Man I

Or, how to invest like a grandmother.

This is a guest article by Pop. Pop writes about the intersection of behavior, economics, and personal finance at Pop Economics. He writes about investing for a living and turns famous economics figures into pop art for fun.

I’m young, as I bet a whole bunch of you are. And because I’m really just a few years into my career, I have a whole host of paths I could take to get me to retirement. The conventional path — which you see in personal finance magazines, target-date retirement funds, and financial adviser crib notes — says you can save a small portion of your income, say 10%, invest most of it in stocks, and be set for your aged 65 retirement.

That’s all well and good. But most of it’s based on a simulation of stock and bond returns. Go to any financial planner or retirement calculator and they’re likely to run a Monte Carlo simulation to show you the probability that their investment plan will get you to your target. You stick in your savings rate, income, asset allocation, etc. and the program spits back a conclusion that reads something like: “With this plan, you have a 93% chance of meeting your goals.”

Let’s just pretend the numbers are accurate. You might walk away from that exercise feeling pretty good about the plan. But what if we turn the language around. What if the program told you, “You have a 7% chance of not being able to retire?” Doesn’t feel so great now, does it? In the not-so-distant past, my company announced it would lay off 700 employees of its 10,000-strong workforce. Somehow it didn’t comfort me that I had a 93% chance of keeping my job.

And, if nothing else, this was the kick in the head that I got from the financial crisis. A 7% chance or 5% chance or 3% chance of missing my retirement goal seems small, unless it’s me who ends up on the unlikely side of that statistic. And that’s what a lot of baby boomers who retired in 2007 or plan to retire soon are realizing now: They’re part of the unlucky 7%.

Well, there is another way. And it’s not one of the newfangled investment products that financial planners are hawking to increase your diversification. No, it’s really a throwback. Back to a time when we didn’t rely on out-sized returns to make retirement possible. In fact, it wouldn’t be so inaccurate to call it “The Grandmother Plan.”

You see, my grandmother was a child of the Great Depression. She saw firsthand how the stock market can both create great wealth and destroy it, seemingly at random. So if you reached a point where you didn’t trust the stock market anymore to grow your money, what did you do? You stuck it all (or nearly all) in Treasury bonds. They’d give you a return three or four percentage points below that of stocks, most of the time, but you never had to worry about losing money.

Today, the ultimate safe investment isn’t Treasury bonds, but their more modern cousin, Treasury Inflation Protected Securities (TIPS). Like Treasuries, these are backed by the federal government. So they’re not going to default. But in addition, their principal is adjusted yearly for inflation. Of course, you could argue that the government underestimates inflation — and this is true. But it gets closer to preserving and slowly growing your money than any other product I’ve seen.

A few economists have argued that retail investors should put all their money in TIPS. You might find that unappetizing. I do too. But instead, some other economists have advocated a middle road. Here’s how it works.

1. Decide what minimum standard of living would be acceptable.

Actually I think the kind of people who read this blog are going to have the easiest time accomplishing this, because you’re already motivated and have self discipline. The problem with most retirement calculators is that they leave out an important element: Humans’ ability to adapt. If we’re running low on money, we spend less. We don’t just carry on until we’re bankrupt. (OK, some people do, but this is a personal finance blog after all.)

To that end, decide right now what your minimum acceptable standard of living would be in retirement. How much could you live on? Would you be willing to, say, move from New York to Wisconsin if it meant you only had to replace 60% of your income instead of 80%? Would you be willing to give up the 4-bedroom house with a yard for a cheaper and lower maintenance condo?

Remember we’re talking worst-case scenario here. This isn’t your “dream retirement.” This is what you don’t want to put at risk. I ran the numbers myself, and I think I’d be willing to live on 70% of what I’m making now (adjusted for inflation, of course). It would certainly involve moving to a lower-cost city — I live in New York City — and it would involve cutting down from two international vacations per year to one. I’d have to eat out less often, and might have to cut out cable TV. Not the perfect life, but I wouldn’t be eating cat food either.

2. Save and invest so that minimum living standard is guaranteed.

Now that you’ve decided what minimum retirement you don’t want to risk, invest so you don’t risk it. Save everything you need to virtually guarantee that retirement by putting it in TIPS. This means that in retirement calculators, when they ask for an estimated, inflation-adjusted return, you’re going to want to put in “2%” instead of the more typical 6% or 8% if you were investing in stocks.

If you want to be especially conservative, don’t include Social Security benefits. I personally don’t think they’ll ever disappear completely, but will kick in at a later age and give you a smaller benefit. And if you’re young, remember that your income is likely to grow faster than inflation as you get promotions and raises. So your income before retirement might be more like $100,000 in today’s dollars if you income at age 30 is $50,000.

What are you likely to conclude? To guarantee your minimum retirement, you’ll probably have to save at least 20% of your income if you’re in your 20s or early 30s, but more like 30% to 40% of your income if you’re in your 40s or 50s. Of course, older folks can simply work for a few extra years beyond retirement age to close that gap a little. But I bet all but people getting started early are going to decide it’s too difficult to save enough.

Calculating exactly what you need to save is pretty difficult. Try using a retirement calculator that lets you adjust your expected return, or go to a financial planner for a 5-hour sit-down, letting him or her know what you’re trying to do. I found a good resource to be the T. Rowe Price retirement income calculator. If you put your desired allocation as 100% short-term, your portfolio earns about 4.75%. With inflation averaging about 3%, it’s a rough approximate of what you’d earn over a long period of time in TIPS. But again, ideally after doing the back-of-the-envelope calculation, you’d find a financial planner to get you started.

Another complicating factor is where to put the money. Many 401k plans don’t yet allow you to invest in TIPS bonds or funds. So you’ll have to find the closest alternative available to you or invest in TIPS outside your 401k. You’ll want to put them in an IRA, if possible, so you’re not taxed each time the principal adjusts for inflation.

I can hear jaws hitting the floor right now. Yeah, that’s a lot of money to save. Probably a lot more than you’re saving. But you know what? That’s the price of safety.

3. Take a risk on the rest.

If you’re able to save more, what do you do with the remainder? Take a risk. Put it in stocks or non-Treasury bonds. Do the things that personal finance mags suggest you do. If you end up approaching the 10% historical average return that you’ve heard so much about, great! If not, no big deal. Because you’ve already sewn up the retirement you need.

Some investors, like Nassim Nicholas Taleb, take this method to extremes. After putting what you need in Treasury bonds, he recommends you really roll the dice, say, on biotech stocks or a clean energy start-up. If you hit oil, the argument goes, you’ll get rich even though you only devoted a small amount of your portfolio to it. If you don’t, no big deal — you’ve locked up what you need anyway.

And all this ends up being a really complicated way of saying this: There’s more than one path to retirement. You might decide you’d rather take the more traditional path. But just keep in mind that it sucks to be in the unlucky 7%.

Editor’s note: The original version of this article cited Boston University’s Zvi Bodie as a proponent of investing entirely in TIPS. Bodie doesn’t not agree with this characterization and has written to Consumerism Commentary explaining his position, which is identical to the central thesis of the article written by Pop. You can read Bodie’s comment below.

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Creating a Risk-Free Retirement Plan

Earlier this month, I stopped my automatic monthly investment of $1,000 in the stock market through Vanguard’s Total Stock Market Index Fund (VTSMX), and it’s possible that this will prove to be a good decision. Shawn Tully from Fortune Magazine identifies four current asset bubbles that all investors should heed, and one of these bubbles is the stock market.

I began my monthly dip into the market with an investment in stocks through my SEP IRA last year around the end of March, so I benefited from one of the lowest recent points to get in the market. I followed that with the automatic monthly investment in my non-retirement account. Through 2009, I was dollar-cost-averaging as the stock market and the price of VTSMX increased.

According to Shawn Tully, you should avoid investing in the stock market, Treasuries, gold, and oil. These investments have all climbed too high recently although the recession is not too far in the past. For stocks, Tully looks at the market’s overall price to earnings ratio, which is historically high right now. This means that companies’ earnings are not high enough to justify the price of shares.

Here is the author’s warning about gold:

Prices are so high all over the world that people who once treasured their gold jewelry are now rushing to sell it. Swiss refiners are offering irresistible prices for bracelets and brooches, “cash-for-gold” stores are in Chicago malls, and suburbanites are hosting Tupperware-style parties where neighbors show up to hock their gold teeth.

When this happened in the early 1980s with silver, prices plummeted from $50 to $15 in less than a year. Look for gold to end up below $500 an ounce within two years.

Are you investing in the stock market or in gold right now?

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Investing During Four Asset Bubbles: Don’t Blow It

Another day, another recall. Normally, automobile recalls are not much of a problem. A recall usually involves bringing your car to a dealership, subjecting yourself up to some sales pitches, getting your car fixed, and driving home. Toyota’s recent string of recalls is more complicated because some of the problems do not have solutions yet.

If you own one of the many Toyota cars affected by one of the company’s recalls, you probably have already received a letter.

Here is what has happened so far:

• November 2, 2009. Toyota/Lexus recalls recent models of the Camry, Avalon, Prius, Tacoma, Tundra, ES350, IS250 and IS350 due to a tendency for the floor mats to obstruct the accelerator pedal. This was a voluntary recall whose solution was simply to remove the driver’s side floor mat. Later that month, Toyota announced a solution to the problem that will require a visit to the dealer.
• November 24, 2009. Toyota recalls 2000-2003 models of the Tundra due to the possibility of excessive corrosion on the frame rear cross-member caused by road salt.
• January 21, 2010. Toyota issues a voluntary safety recall for recent models of the RAV4, Corolla, Matrix, Avalon, Camry, Highlander, Tundra, and Sequoia. This recall is to remedy another problem with the accelerator. In these cars, there may be a tendency for the accelerator pedal to stick, and this is not related to the floor mat problem. On Tuesday, January 26, after months of working with federal safety officials, Toyota decided to stop selling these cars until the problem has been fixed.
• January 27, 2010. Last night, Toyota added to its initial recall pertaining to floor mats obstructing accelerator pedals. Added to the initial list are recent Highlanders, Corollas, Venzas, Matrixes and Pontiac Vibes. The Vibe shares design and construction with the Toyota Matrix.

According to the New York Times, sudden, uncontrolled acceleration in Toyota vehicles has caused 275 crashes and 18 deaths. Researchers have identified 2,274 incidents of sudden acceleration.

Over the past few months, Toyota has recalled 7.6 million cars. General Motors was quick to respond with an incentive for Toyota owners who want to get rid of their cars in favor of one of the American automaker’s vehicles.

Toyota has a strong reputation or being reliable, but these recent events inspire doubt. Here in the United States, shares of Toyota Motor Corp. (TM) have fallen 13% since January 19. If you believe that Toyota will recover, and if you have money you don’t mind losing while gambling in the stock market, it might be a good time to buy Toyota’s stock. I expect Toyota will recover and after some time, their reputation will remain mostly unharmed.

Update: I decided that if I should talk about buying TM, and if I think it’s a good idea for the long term, I should live up to my decision. I bought 10 shares of Toyota Motor Corp.’s ADR today.

Do you see the latest string of crises as an opportunity for investors?

Photo credit: Collin Allen
Dealers Swamped by Worried Toyota Drivers, Associated Press, January 28, 2010

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More Toyota Cars Recalled: Time to Buy Shares of TM?

Well, I didn’t want to have to make this decision, and I know that all of you smart people will think I’m making a mistake, but I’ve decided for the time being to stop making pre-tax investments into the 401(k)-like thing that my company operates.

Over the last year I’ve directed $1,879.18 out of my paycheck into that IRA, and as of yesterday the account was worth $2,181.61, which is an increase of $302.43. That’s an overall return of just over 16%, which is well outperforming the Dow Jones and the S&P 500.

Unfortunately, I’ve still got this credit card debt hovering between $5,000 and $6,000, and the finance charges are easily outstripping any benefit from investing in the IRA. I feel like I’ve made a terrible mistake by taking the advice of the CPA I consulted, and that I could be feeling a lot better about my future right now had I not started investing.

This decision was made easier for me when I remembered that the main benefit of contributing to the IRA was that my employer was also contributing free money in my name, and that they stopped last year around the same time all of our salaries got a 10% reduction. What’s more, this particular investment comes with a front-loaded 5.75% transaction fee. When my employer was contributing, this fee was annoying but not enough of a deterrent. Now, if I felt like I should be contributing any pre-tax money, I could find a better option just about anywhere that didn’t charge me that much.

So, I’ve stopped. And now I can pay off my credit card at a rate of $1,000 per pay period instead of $900. Of course, I’m still using this card for daily purchases, so it won’t be paid off in three months, but I have managed to start making lunch instead of buying it every day. If it weren’t for the ever-present vet appointments, car maintenance ($518 for new tires), out-of-the-blue-surprise dermatologist bills ($178 for stuff I thought was already paid for a year ago, because we have the best health insurance in the world), and of course the dentist (nearly $800 so far), I’m sure that debt would seem a lot more manageable.

I’ll probably have to stop making dentist appointments, too.

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Between a Rock and a Hard Debt

With new technology becoming available to consumers every day, like 3-D high-definition televisions, it certainly feels like I’m living in the future. How did we all survive without such marvels as wireless internet, video games that react to movement, GPS, text messaging, and video on demand? In ten years, we could as easily be wondering how we functioned in the early twenty-first century without flying cars, time machines, and cellular phone brain implants.

While it may feel like we’re living in the future, we’re not. Although it’s very tempting to focus purely on what is needed right now, this philosophy could set anyone up for financial failure. At the beginning of a career, it’s not difficult to fall into this trap. Starting salaries are not always large, and these days people are often well aware of how their salaries compare with those of their colleagues. This contributes to the feeling that when you’re struggling to afford the basic necessities, saving for later is impossible.

When I graduated from college, I worked at a job that was fulfilling in many ways other than financially. I wasn’t paid enough to be able to eat, afford a normal rent, and commute to work. Saving for the future didn’t even enter my mind. Even when the small non-profit organization established a 403(b), I couldn’t conceive how I could send any portion of my salary to anything other than the “present me.”

After some time I realized I wasn’t thriving financially and I educated myself about money. By the time I started my next job, I knew I had to think about and plan for the “future me,” even if it meant temporarily making some sacrifices.

Why save for the future?

A few weeks ago, Outlaw made an interesting argument about why it’s better to focus on the present and ignoring the future. I don’t agree, but there are some valid points:

• You should only plan for what is likely. If your genetics indicate you will not live a long life and if you have no purpose for accumulating money other than using it for yourself, then by all means, live every day like it is your last and spend away.
• The purpose of money is for it to be used, not to be sitting in a bank account. This is why I believe statements like, “My goal is to have a net worth of ten million dollars,” are not real goals; they don’t explain anything.

The basics for you and your family are not fully covered until you think about future needs. Being able to enjoy what life has to offer in the present is a luxury. In a perfect world, we could do both — invest for the future and use money to better ourselves today.

How to invest for the future

I often hear that it’s better to just get started investing as early as possible, to take advantage of the power of compounding returns, and that’s better to just do something rather than taking the time to do something right. Voltaire wrote, “Le mieux est l’ennemi du bien,” and this is often interpreted to mean that obsession over doing something the best way prevents any action at all. This is further extrapolated to rationalize not performing due diligence before making an investment decision. In other words those who follow this philosophy might say it’s better to get into the stock market now in the easiest and quickest manner and worry about specific investments later.

There’s some truth to that, and that’s why many companies automatically enroll new employees is 401(k) retirement plans. But the default investments may not be ideal. So here is what you need to do now to save for your retirement or the future in general.

Invest in your 401(k) but choose the best options. Many 401(k) plans let you choose a risk profile, like “aggressive” or “conservative,” and they do the rest. If you are aiming for bien rather than mieux this is a good start. If your 401(k) offers a low-cost broad index fund, this may be a better investments than the underlying funds in an automatic portfolio based on a risk profile. With a 401(k) plan, your income is reduced by the amount you invest, but you will pay income tax when you eventually withdraw your money during retirement.

Many companies that offer 401(k) plans also increase the benefit by matching your contributions up to a certain percentage. This is “free” money so you should try to make the most of that benefit. Nothing is truly “free.” Many times you have to work at a company for a certain amount of time before your employer matching contribution becomes truly yours. Corporations need to use delayed rewards like these to help retain good employees who might be talented enough to find more creative ways to earn income.

Maximize your Roth IRA investment. It’s hard to know what income tax rates will be in the future, but with the way the economy is now, it’s not unreasonable to expect tax rates will be higher by the time you retire. Roth IRAs are optimized for that assumption compared to pre-tax 401(k) plans; you pay your income taxes now at what might be lower rates than those later.

While a company creates your 401(k) choices, you are free to invest in just about anything for your IRA. My IRAs are mostly held at Vanguard where I can choose from a selection of low-cost index funds.

Maximize your 401(k) contribution. After you’re investing the full amount to your Roth IRA you can turn around and look back at your 401(k) contribution. You can increase the amount you defer to your retirement plan up to the contribution maximum mandated by the IRS or your employer.

These are only some suggestions. Not everyone has access to 401(k) plans or 403(b) plans. There are other investment options like SIMPLE IRAs, traditional IRAs, and non-retirement accounts that can be used efficiently to prepare for the future.

The future is not just retirement

There is more to the future than quitting your job and moving to an “active adult community.” Think about what you might want five, ten, or twenty years from now. If a house is in your future, you should save for a large enough down payment. But if you plan on making the purchase within ten years, you may want to invest outside of the stock market as you never know when the next market crash will arrive. Bad timing could wipe out your savings.

Don’t forget to think about people other than yourself, particularly those in your family who rely at least partly on your income. For example, you may want to invest for future education for your children.

If you think you might need the cash for a goal upcoming within a year or so, high-yield savings accounts, high-yield alternatives, or even laddered certificates of deposit (CDs) provide the liquidity you need.

If your money is limited, the more aggressive you need to be. For example, Suze Orman suggests investing for the long term in stocks. That’s good advice for most of her audience. You’ll find that she invests only 4 percent ($1 million) of her own portfolio in stocks and most of the rest in bonds. Even a modest return on those bonds provides her $1 million in annual income. With a net worth like that, Suze Orman can afford to be more conservative.

Find the right balance

All this planning for the future is a smart way to reduce the possibility of struggling later in exchange for living like tomorrow will never come. Life is short. The time we have with our family and friends is limited. Before you know it, life has passed you by. There has to be an optimal balance between saving money for the future and using money now to make the most our of life.

As I mentioned above, being able to do both or to find balance is a luxury. Many people throughout this world struggle to afford a minimum amount of food every day. They are not thinking about retirement nor are they thinking about their next family vacation. Most readers of Consumerism Commentary are exceedingly lucky to have been born in a prosperous time in an advantageous location. Those of us earning money have the ability to invest for the future. There is no reason for us to sacrifice our future to live for today or to sacrifice an enjoyable life now for the sake of our future as long as we take a sensible approach to balance.

This article is part of a series called Start the Decade Off Right on Consumerism Commentary. Previously: Pay off debt, open a high-yield savings account.

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Start the Decade Off Right: Invest For the Future

In 2010, the basic maximum for 401(k) contributions is $16,500. Employees 50 and older can add an additional $5,500. These limits take your pre-tax, after-tax, and Roth 401(k) contributions into consideration, so the sum of all your 401(k) contributions in 2010 cannot exceed the limit for your age group. This limit is the same as last year’s amount. This comes as a pleasant surprise because there has been some discussion about the IRS actually reducing the maximums for 2010.

401(k) contributions may be further limited by your employer. Mine limits 401(k) contributions to 50% of an employee’s salary.

I contributed the full amount of $16,500 to my 401(k) in 2009. Unfortunately, I didn’t realize I had one extra paycheck in 2009, a total of twenty-seven rather than twenty-six. This resulted in my employer diverting no portion of my final paycheck towards my 401(k) and thus I missed out on a small portion of employer matching contribution. Employer matching contributions generally end when your contributions are maxed out.

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401(k) Contribution Limits For 2010

Other than the removal of the income limitation for Roth IRA conversions this year, 2010 is not much different than 2009 in terms of IRA maximums. Like 2009, the maximum you may contribute to your Traditional and Roth IRAs combined is $5,000. If you reach age 50 this year, you may contribute an extra $1,000 for a total of $6,000. This maximum applies to the combined contributions between your Traditional and Roth IRAs.

The income limitations for contributing to a Roth IRA have changed slightly this year for taxpayers who are married and file jointly. For these filers, if the modified adjusted gross income (MAGI) on the tax return is above $167,000, the Roth IRA maximum begins to reduce to zero, phasing out completely with a MAGI of $177,000. Those amounts have increased by $1,000 since 2009. For taxpayers who file as single, the phase-out begins at a MAGI of $105,000 and the benefit is fully eliminated with a MAGI of $120,000.

These income limitations do not apply for conversions from Traditional IRAs to Roth IRAs.

If you haven’t contributed the full amount to your 2009 IRA, there is still time to do so. You have until your tax filing deadline to complete the contribution. For the past few years, I’ve waited until I file my taxes to contribute to my IRA. For us, the 2009 contribution limits apply.

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Traditional and Roth IRA Contribution Limits for 2010

Yesterday, FaithShares added two new exchange-traded funds to their lineup, already consisting of funds called “Catholic Values,” “Christian Values,” and “Methodist Values.” These and the two new funds, “Baptist Values” and “Lutheran Values,” focus on investing in only those companies that live up to the values encouraged by each of these communities. It is more accurate to say that these funds look to invest in companies excluding those that do not meet their expectations.

For example, the Baptist Values Fund avoids companies involved in gambling, tobacco, alcohol, pornography, or abortion.

I understand the appeal of being a good steward of your money by investing in funds tailored to the values held important in a community, heritage, or a religion. These religion-based ETFs are not much different than other funds that cater to other value-related movements. Socially-responsible funds are marketed to environmental activists or people interested in expanding human rights. While religion-based funds focus on eliminating investments in companies associated with sins, socially-responsible funds seek to invest only in companies with the same values.

Regardless of the choice between values-based or socially-responsible investments, the main purpose other than earning money for the fund managers is to make the investor feel comfortable. Regardless the affiliation, people with strongly-held convictions make great target demographics. It may be a smaller group of investors than would be reached by broadening the audience, but they are willing to pay more for products and services that appear to be aligned with their closely-held priorities.

While investing, success in avoiding companies that do not conform to your values in nearly impossible. Curiously, the FaithShares funds do not list each fund’s holdings in either their prospectuses or statements of additional information. While the direct holdings may well fit the requirements, every company works to invest its own capital. These investments could be in other companies that add yet another layer of investment complexity. Unlike the companies in which the funds invest directly, these subterranean investments, sub-subterranean investments, and deeper are not screened for their compatibility with the marketed values.

As Marketplace observes, “… because of the narrow focus, you wouldn’t want to make one of these ETF’s the core of your investment strategy.” In other words, to invest appropriately you need broader diversification, resulting in investments outside of those screened by fund managers to match your life philosophies. To be a good steward of your money, you need to look beyond the investments designed for your value niche.

If you want to feel good about your investments, then by all means, choose funds that cater to your values. It’s likely you will pay more and earn less than investing in a broader mix of stocks. But if you want to make a difference with your money and support companies you believe in, work within your community or with those companies directly.

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

Are Values-Based and Socially-Responsible Investments Worthwhile?

The United States must be approaching the end of the recession when economists begin offering their retrospectives. Even if the data are pointing to an end to the recession, in technical terms, the economy is a long way from recovery. Just look around at the people out of work. Even those who have maintained their jobs are finding it difficult to qualify for mortgages, keeping the real estate industry itching for more handouts like the extension to the home buyers’ tax credit.

And some economists are not convinced that the worst is over. We may be in the lull of a double-dip recession. Wherever the economy is, making predictions, like critiquing wine, is often no more accurate than randomness.

For Fortune Magazine, economist and actor Ben Stein contributed four of the lessons he learned during the recession.

• Economic forecasting is still an extremely difficult gambit
• Financial market forecasting is even more troublesome
• The amount of lying and deception by the financial sector of this country has been breathtaking
• The government has no special abilities to forecast or predict a darned thing

Ben Stein is usually a strong supporter of the financial industry, so it’s nice to see him pointing out some of the flaws inherent in the system. He goes on to reassure investors that staying invested in stocks and bonds while keeping enough liquidity is the best way to weather recessions in the long term. If the second dip rears its head, I would like to believe it will provide more opportunities for investing for growth over the coming decades.

Are you prepared for the next recession?

Photo credit: simonhn
4 lessons from the recession, Ben Stein, Fortune, November 19, 2009

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Ben Stein Offers Four Lessons From the Recession

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Roth IRA conversion rules are changing next year. Even if you make more than $100,000, you’ll be allowed to convert Traditional IRA money into after-tax Roth money. You can even spread the tax payments out over a few years to make it easier if you convert during 2010.

Does it make sense to do so?

We’ve touched on the 2010 Roth conversion rules before. Let’s dig deeper into why it may or may not make sense to convert.

Why convert?

The 2010 conversion rules may help some taxpayers. In general, the opportunity is more attractive if:

• You think tax rates are headed higher
• You’ve been making nondeductible IRA contributions
• You have a high net worth or you want to leave more for your heirs
• You want to diversify the tax status of your money, just like you diversify your investments

Higher tax rates

With higher tax rates in the future, you can get your tax payment out of the way now — at a lower rate. What might make tax rates higher in your retirement years? You could have higher earnings, lawmakers could raise tax rates overall, or both.

With all the talk of government bailouts and broken entitlement systems (like Social Security and Medicare) it’s easy to see why rates could go up. The government needs money, but the solution may not be as simple as an income tax rate increase. There are other ways they can drum up cash:

• Consumption or value added taxes (VAT)
• Change how much you and your employer pay for Social Security
• Change limits on retirement plan contributions
• “Forget” to change certain limits with inflation (IRA and retirement plan contributions, compensation recognized for Social Security and retirement plan calculations, etc)
• Change the laws and make Roth distributions taxable (or potentially taxable, like Social Security benefits)
• Other strategies I’m not smart enough to understand

If you’re betting on higher tax rates, make sure you understand how the bet can go wrong.

Nondeductible contributions

If you’ve been making nondeductible contributions, you’ve practically made Roth contributions anyway. In fact, you probably couldn’t deduct the contributions because you make too much money. For you, the conversion option is worth investigating because it would allow you to get the earnings out tax-free – as opposed to just the contributions.

Ideally, you’ve been making nondeductible contributions in recent years, and you have little or no earnings in the account after the recent market decline (sometimes there’s a silver lining). If so, the tax hit may be minimal. However, you should look at all your IRA accounts in aggregate to figure out how much it’ll cost.

Diversify, diversify, diversify

Diversification is another decent reason to consider converting. Most people have all (or a majority) of their retirement savings in Traditional pre-tax accounts. They’ll have to pay income tax as they spend that money. Since we don’t know what tax rates will do, it may make sense to hedge your bets.

If you have a choice of funds (pre-tax and post-tax) in retirement, you can choose whether or not to increase your tax bill in a given year. Suppose you do some consulting work and earn money – it may make sense to take a Roth distribution that year. On the other hand, you can take Traditional distributions when you have little or no taxable income.

Estate planning

If you’re fortunate enough to have an estate planning problem — or just more money than you need — then Roth money can come in handy. By converting, you pay taxes today so your heirs can take tax-free distributions (unless they change the rules and start taxing Roth distributions, of course). You also remove money from your estate when you pay the tax bill.

You’re required to take distributions from Traditional IRAs during your lifetime, starting after you reach age 70.5. The government wants you to generate some tax liability on all that money you’ve been protecting, so they force you to dribble it out over your remaining years. Roth IRAs do not have this requirement, so you can leave more for your heirs.

Proceed with caution

If the idea attracts you, don;t rush into anything. In the coming months, we’ll learn more about the complexities of the 2010 conversion rules, and how the landscape may change (for example, will tax rates increase in 2011 and 2012 — making it less attractive to spread the payments out?). Unless tax rates in your retirement years increase substantially, you probably won’t hit a home run by converting. However, you might come out ahead or just enjoy having more flexibility in retirement.

Remember that if you earn over $100,000, you’re already in a fairly high tax bracket (at today’s rates at least). A conversion won’t be cheap, and you should pay the taxes due from savings available to you outside of your retirement accounts.

Give your eyes a break and listen: a recent Consumerism Commentary podcast has more insight into the 2010 conversion rules.

Will you take advantage of the Roth conversion rules next year? Why or why not?

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

2010 Roth Conversion: Good Idea?

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Target date funds are under scrutiny in Washington as lawmakers figure out if they work the way they’re supposed to.

Also known as lifecycle funds, these funds become less risky as time goes on. They’re popular in 401(k) plans and other retirement plans because they make diversification easy. You select one target date fund from your plan’s menu, and that fund spreads your money among numerous underlying funds.

Most people are told to select the fund that has a number closest to their retirement year. Plan to retire soon? You might choose the “2010 Target Date Fund.” If you’re 26 years old, you might select the “2050 Target Date Fund.”

These funds are also common in 529 college savings programs where they may be called “age based” funds. The concepts are the same, so we’ll talk in terms of retirement for now.

For some, especially those who will not put time and energy into studying their investments, target date funds are a fine choice. They offer diversification and continuous re-balancing. They may have exposure to things (alternative strategies, commodities, or sector funds) you can’t find on your plan’s menu or that you don’t have enough money to buy into.

However, they’re far from perfect. Let’s cover a few of the major problems and what you can do about them.

What’s the right mix?

There are dramatic differences in how they’re constructed. For example, consider two funds with a target year of 2010. This would be a fund designed for an older investor — planning to start spending the money within a year — who presumably does not want to take much risk.

Fund Company A’s 2010 fund might have 26% in stocks, but Fund Company B’s 2010 fund might have 72% in stocks. Indeed, that’s exactly what happens. Morningstar published a study showing equity exposure in 2010 funds, and results are all over the board. Do most 65-year-olds want 72% of their money in the stock markets?

Critics suggest fixing this problem by standardizing equity exposure for each target year, or at least requiring more understandable charts showing the fund’s risk level. Some investors may be comfortable with high risk portfolios, but they should at least know what they’re getting into.

Who’s running the money?

Target date funds are made up of 10 to 30 underlying funds. Are those funds any good?

Critics argue that some fund companies put poor funds into their target date funds to feed money into those poor funds. If that’s the case, the Large Cap Value portion of your target date fund may be run by an under-performing manager or team. Of course, this is less of a risk if the fund company only uses index (or passive) funds.

The best target date funds are probably multi-fund-family funds. For example, T. Rowe Price’s target date funds are composed entirely of T. Rowe Price mutual funds. John Hancock uses different money managers to subadvise pieces of their target date funds. This lets them use best-of-breed managers for some portions of the portfolio and index funds for other portions.

Note that I have nothing against (nor do I endorse) either of the above companies; this is just food for thought.

What about fees?

It’s always hard to tell how much you’re paying with a mutual fund. Target date funds are especially tricky because they’re made up of many underlying funds. Most companies disclose “overlay” fees, the fee for creating the mix of investments and managing it over time, in a prospectus, but few investors look under the hood.

Multi-fund-family funds may have arrangements that create potential conflicts of interest. Why is one manager used instead of another? Hopefully it’s because of superior management, but you know it’s not always that simple.

Finally, some say that target date funds have excessive equity exposure because equity funds generate more revenue. That may help explain why a 2010 fund has 72% in stocks.

What can you do?

Target date funds are designed to make life easy, so requiring you to do homework kind of defeats the purpose. However, they’re out there and they may be your only option (or the best option available to you). It pays to know how they work and how you can improve your chances:

• Ask for help. Your 401(k) provider, financial advisor, or DIY investment company should be able to help you figure out what you’re investing in.
• Look under the hood. Understand how much is in stocks, bonds, foreign assets, and other assets. Are you comfortable with that mix?
• Make changes. If you don’t like what you see, use something else. If you’re limited to your employer’s retirement plan menu, consider using other investments. Talk to the HR department about your concerns.
• Bend the rules. Target date funds are designed for you to put 100% of your money into a fund with a target date near your retirement date. You can always use a different year to increase or reduce risk, or you can put 80% into the target date fund and 20% into another fund.
• Lean on regulators. Let them know what’s important to you or hope for the best.

Tell us about your experience with target date funds. Why do you use them or avoid them?

This is a guest article by J.J., one of six finalists interested in being Consumerism Commentary’s staff writer.

Photo credit: eyeliam

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

The Trouble With Target Date Funds

The Security and Exchange Commission (SEC) is setting up a new division to oversee new financial products, and this group is starting with target date funds. These are mutual funds usually taking the form of baskets of other mutual funds, designed to target a certain year of retirement. As the year approaches, the fund automatically changes asset allocation, usually between stocks and bonds, to become less risky.

I’ve pointed out some of my concerns with target date funds here before. Mainly, they could be too conservative and it’s easy to hide fees. Mary Schapiro, the head of the SEC, pointed to the exchanges from stocks to bonds. The cost of the sales and purchases is buried in the daily price of the target date fund, and there is currently no good way for customers to understand how much they are being charged for the re-balancing of the portfolio they could do on their own.

Schapiro also noted that there is no standard across companies. A target date fund designed for those who plan to retire in 2050 with one fund manager may have a different allocation between stocks and bonds than a 2050 target date fund with another fund manager.

Here is a comparison of the asset allocations for the funds designed for those retiring in 2050 from Vanguard, Fidelity, and T. Rowe Price.

The variation seems small but could have an significant effect on returns by retirement in 2050. If target retirement funds were standardized across companies, customers could accurately and easily compare returns between fund managers, understand the level of risk, and have the opportunity to make better investment decisions.

I am not convinced there is a need for this. Any fund’s composition is described in detail in the prospectus and in on a multitude of financial data websites like Yahoo Finance and Google Finance. What isn’t clear are the true fees. We do know that Vanguard’s fee for their 2050 fund is 0.19%, Fidelity’s is 0.82%, and T. Rowe Price’s is 0.79%, but that only tells part of the story. Whenever there is turnover — stocks are sold and other stocks, bonds, or other investments are purchases — fees are generated but wrapped tightly into the daily price of the fund so it is barely noticeable.

Asset re-allocation is the purpose of target date funds. Even if the underlying funds, those in the basket, are low-turnover index funds, the managers may be rearranging the index funds in the basket often. For those disciplined to handle the responsibility of occasional re-balancing themselves, and it’s not that difficult, I suggest avoiding target date funds.

Target date funds have lots of fans because it’s a form of automation, and automation in finances is usually a good thing. There is a danger of automation leading to complacency and a false sense of security. If you choose target date funds, familiarize yourself with the details and evaluate whether the pre-packaged re-allocation system is worth the thousands of dollars or more you could be losing in hidden fees and with a risk profile that doesn’t match your income needs and tolerance.

Would you like to see target date funds standardizes so a “2050 Fund” from one company matches a “2050 Fund” from another company? or should companies be left to determine what strategy is best for their customers?

Photo credit: viZZZual.com
‘Target Date’ Funds Get Senate Scrutiny, Daisy Maxey, Wall Street Journal, October 30, 2009
SEC to look at retirement investing risks, Marketplace, November 3, 2009

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Should Target Date Funds Be Standardized?

Peer-to-peer lending institution Prosper is offering a $50 bonus for new lenders who sign up for for the service and bid on two loans. Peer-to-peer lending is an interesting way for people to qualify for loans and to lend money to others. In an economy where savings account interest rates are under 3% or 2%, it’s tempting to put cash to better use through these direct loans. There is a possibility to earn much more than you would by putting cash in a savings account as long as loans are chosen carefully and you’re willing to accept risk.

There is something appealing about working outside the banking system. Peer-to-peer lending takes a specific power of the financial industry and puts in the hands of individuals.

I tried Prosper a few years ago. A friend of mine was looking to consolidate his credit card balances, but was looking for a better option that putting several thousand dollars onto one high-interest card. His plan was to apply for a loan on Prosper and use the funds to pay off his credit cards. He would then only need to worry about one payment each month with a lower total payment and a lower interest rate than what he would likely get with a credit card.

When he asked me about Propser, I offered to help him out by bidding to provide a portion of the funding for the loan. The idea of being an investor appealed to me, but unfortunately, the state of Texas prevented him from participating on Prosper at that time. It is my understanding that he would qualify only for an interest rate higher than allowed by the state.

My adventures with Prosper ended before they began. And I won’t be able to get started. As I began to research investing in a portfolio of loans at Prosper and bidding on individual loans, I was greeted by this message:

Unfortunately, at this time lenders in New Jersey are not able to bid or transfer money to Prosper. If you have portfolio plans, they have been paused. You may transfer money out of your Prosper account as they become available from loan payments.

If you reside in a state where Prosper is allowed to do business, consider signing up for an account and qualifying for the $50 bonus. What is your experience with Prosper?

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

$50 Bonus for New Prosper Lenders

I’ve been investing in a 401(k) retirement account since I joined the ranks of the corporate employed seven years ago. I started with a small percentage of my income, just enough to take advantage of the full company match. As my income increased, I diverted a larger percentage to the 401(k) with the hopes of retiring with a sizable nest egg decades later. I’m at the point now where I am contributing the full amount allowed by law.

This plan has worked well for a while. But like most people in similar situations, my 401(k) suffered damage over the past year or two. I figured that over the course of my career, I’d hit a recession at some point, and I suppose I am lucky that I am not forced to retire and begin drawing income right now, with the account value depleted.

Here is a graph that depicts my 401(k) account value since January 2004.

The cost basis, or the amount I invested, is represented by the line and the market value of the account is represented by the bars. Ignore the bump in the cost basis at the end of 2004. That should be a smooth curve. From 2005 through most of 2007, my account was performing quite well. Soon after that, the value fell below my cost basis. I was losing money on paper.

I continued to invest in my 401(k) every other week. Even with increased investments, my account has not caught up to my cost basis. The Employee Benefit Research Institute and the Investment Company Institute recently released a report that shows that many investors have been able to bring their 401(k) account balances above the level recorded at the beginning of 2008. I fall into this group, but at the beginning of 2008 my account value was higher than my cost basis. As of today, the total value of my 401(k) is below my cost basis.

In other words, if I had been putting the portion of my paycheck that I had been investing in my 401(k) into a bank account — or even kept cash under my mattress — I would have fared better. So far. The good news is that while I was investing throughout the past few years, I was, I hope, purchasing funds at relative bargain prices. If stock market performance returns to average over a long period of time, I should be in luck; those bargains will pay off.

What is the state of your 401(k)?

401(k) investors: Hit hard in ‘08, doing better now, Jeanne Sahadi, CNNMoney.com, October 6, 2009

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

How is Your 401(k) Retirement Account Performing?

Earlier this week, I reviewed common financial rules of thumb and offered a quick evaluation of how each rule would likely perform if accepted by an individual as the final word. One of these was the rule that convinces retirees they will be financially secure if they withdraw 4% of their nest egg for income one year and continue withdrawing the same amount adjusted for inflation each year.

Walter Updegrave has a much more detailed strategy for retirees who would like to make their money last from age 65 to 95 and beyond. He offers three alternatives that one can follow depending on their assets and their needs in retirement.

Three strategies for retirees

The first strategy is for retirees who have enough income from Social Security and pensions to cover basic expenses and who are confident in their ability to manage their portfolio.

For those in this situation the 4% withdrawal rule has a chance of succeeding — having your money last 30 years — 77% of the time. If you need more income than 4% would provide, you’re risking not having enough to last that long. For example, someone retiring today with a $1 million nest egg could withdraw $40,000 that first year. But if you’re 33 years old like me, you better plan on having much more than $1 million when you retire; thanks to inflation, an income of $40,000 thirty years from now will probably not be sufficient.

In order to maintain a 4% withdrawal rate, according to the article, is to maintain a portfolio of 50% stocks and 50% bonds. And by the way, a bad year in the stock market could wipe you out.

The second strategy offered by Walter Updegrave is for retirees who need more income for basic expenses than is provided by Social Security and pensions or who do not want to subject their portfolio to as much risk as required in the first strategy.

Take part of your nest egg and purchase a lifetime immediate annuity. This will provide you with steady paychecks for the rest of your life. According to the article, recent annuities pay out 8%, so you would only need $500,000 to make that $40,000 income mentioned earlier. These are most beneficial for people who live longer because money is pooled with other investors. Those who die earlier help fund the incomes of those who survive in retirement longer. The problem with annuities is your money is often locked inside them, and you can’t get it if you need it without paying steep penalties.

Walter Updegrave also offers a third strategy for retirees who need more income than Social Security and pensions provide but want access to more of their money. In addition to a portfolio of stocks and bonds, and an immediate lifetime annuity, add a variable annuity with a guaranteed lifetime withdrawal benefit to the mix.

Variable annuities are flexible but they are also expensive. Rather than 8% like the lifetime immediate annuity above, a 65 year old is likely to receive a 5% return. It is not rare for these accounts to charge a fee of 3% of your account balance each year. The author suggests that the optimal mix between these products and investments would be 25% of your portfolio in variable annuities, 25% in immediate annuities, and the remaining 50% in the diversified portfolio of stocks and bonds.

The problem with annuities

The sale of annuities, particularly variables annuities, is riddled with problems. These are very popular products for salespeople because they make a lot of money for the companies that sell them. It’s not rare for salespeople to misrepresent the product. Often customers are not given the full information regarding withdrawal penalties.

Here’s an example of an 86-year-old man who was pressured into buying a product he did not understand and would never benefit from. Dateline investigated annuities salespeople and found more deception in the industry. Ben Stein, however, credits variable annuities for making his parents rich, though it might be important to note that a Ben Stein’s long-time working partner is Phil DeMuth, a registered investment adviser (salesperson) who benefits financially when more people are convinced that annuities are good products.

How to make your money last, Walter Updegrave, Money Magazine, September 23, 2009

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Three Detailed Income Strategies for Retirement

This is a guest article written by Clare, the founder of MoneyEnergy, where she writes about international dividend investing, DRIPs, and increasing your cashflow. If you like this post, consider subscribing to her RSS feed to get others like it in your reader.

DRIPs (dividend reinvestment plans) were fairly popular back in the 1980s I am told, but now that there are so many low-cost discount brokers, the argument goes, DRIPs are less desirable. Some don’t see what’s so special about them. For others, they’re just plain boring.

I’d like to give you a few good reasons why you should take another look at DRIPs — or check them out for real if you have never done so and aren’t familiar with them. If you don’t know what DRIPs are, you are about to find out.

1. Even with low-cost brokers like Zecco, the best DRIP plans are still cheaper: they’re FREE. They have no commission or reinvestment fees whatsoever. There are no minimum trades you need to make or minimum amounts you need to keep in your account. The cost doesn’t rise after the introductory offer expires. This means you save a lot of money.

2. Networking and computer technologies have enabled transfer agents to store account information and make it available to you online. There is no longer any reason to be concerned about folders and folders of account information and paper records that you need to keep track of yourself. Purchase price information, downloadable forms and tax documents can now all be had online, if you choose to do it that way. You can still, of course, just elect to receive your account information in the mail as always.

4. DRIP plans run through transfer agents like Computershare will reinvest 100% of your dividends back into the stock, not just the amount that will purchase a new share. This has always been a feature of DRIPs. Most brokers do not do this. The ones that do will only reinvest your dividends if they are enough to purchase at least one new whole share. With fractional reinvestment, your money goes to work for you sooner than if you had to wait to own enough stock to buy new shares with those dividends. This means DRIPs are still the best choice for young people or those just starting investing who might not have huge sums of seed money.

4. DRIP stocks are “pre-screened,” so to speak. Let me explain: First, the only companies who can offer DRIPs are those with dividend payouts. Second, companies with DRIPs tend to be well-managed and are interested in keeping their cash flow within the company (simply having a DRIP plan can save them numerous fees). DRIPs give them more flexibility and leverage in times of need as well as times of opportunity (such as acquisitions). Being dividend-payers, they are probably slightly more mature companies and are likely to be less volatile than the market average. Common DRIP stocks, for example, are utilities and consumer goods companies, like Proctor & Gamble. None of this means your DRIP stock is without any risk or that you shouldn’t do your homework, but I believe it does narrow down your selection and make it easier to spot value.

5. The best reason of all, however, that DRIPs are still attractive investment vehicles, is the ongoing discounts many provide on share reinvestment and optional stock purchases. Some companies offer anywhere from a 2-4% discount off the market value of their shares on the day of purchase. You won’t find that anywhere else! Companies do this as an incentive for you to invest and to use their DRIP plan, which, as mentioned in #4 above, benefits them considerably. Compound this benefit with the savings you’ll have on commissions, and you can see how much farther your money can potentially go, and sooner, with DRIPs.

DRIPs are no longer much of a secret in the investing world, but organized information on them can be hard to find. For a more detailed primer on how to get started in DRIP investing, take a look at this guide I wrote to commission-free investing.

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5 Reasons to Take Another Look at DRIPs

I do very little stock trading. In fact, the only individual stocks I hold are Microsoft (MSFT) and Akamai (AKAM), both of which I purchased with free money for opening a brokerage account. Naturally, I think free cash is a perfect candidate for experimentation with the stock market and I most likely would not have made these purchases without this particular incentive.

Zecco Trading is offering a different incentive for those who have funds for trading stocks but would like to avoid pesky transaction fees that eat into your returns. For a very limited time, Zecco is offering 20 free traders. This discount brokerage normally offers 20 free trades each month for customers who maintain a $25,000 bonus in their account or execute 25 trades each month. Otherwise, each trade costs $4.50, still one of the lowest transaction fees available.

Here is how to receive 20 free trades without meeting the minimum balance or minimum trade volume. First, be a new customer. Only new Zecco customers are eligible. Apply for your Zecco account here, and use the code bonus1 when signing up for your account. Your application must be complete and approved by September 13, 2009.

As long as you meet the above criteria, you will see 20 free trades available in your account by September 16, 2009.

For more options, see this summary of five true discount brokerages.

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Zecco Trading Offering 20 Free Stock Trades

For the last few years, I have been participating in my company’s stock purchase plan at the maximum level. Every paycheck, ten percent of my gross salary is withheld. At the end of each quarter the funds are used to buy my company’s stock at a 15 percent discount from the lower price of either the first day or last day of the quarter. As my company’s stock declined mostly due to the economy at large and the industry in which I work, this was a losing proposition. I decided not to sell the company stock until prices returned, rather than selling at the first available opportunity as I had been earlier.

So now I have company stock that I have been holding since December 31, 2007. About half of the shared purchased then and since then are in a losing position while half are now in a winning position. My only opportunity to sell this quarter is closing soon, so I should decide what to do. Here are some of my options:

• Sell all of it. It’s risky to hold so much in one stock, and I already have company stock in my 401(k). I can write off the losses against the gains to reduce tax liability.
• Sell the shares in a losing position. I can write off the losses against any realized gains if I sell stocks later this year.
• Sell nothing until they are held for two years. The stock will probably go up, and after two years, they will be long-term capital gains, taxed at a lower rate.
• Sell the shares in a winning position. This would help my cash flow, but I’ll owe income tax.

What would you do?

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Employee Stock Purchase Plan Dilemma

The option to convert a Traditional IRA to a Roth IRA has been around for a while. Here are the differences between a Traditional IRA and a Roth IRA for those new to these retirement accounts. As long as your modified adjusted gross income (MAGI) is under $100,000 you have qualified for this conversion. Contributions to the Traditional IRA is tax-deductible, which means that your tax bill is calculated after ignoring the amount you deposit into the IRA. You will pay those taxes after you retire and begin withdrawing these funds. If you have a higher tax rate now than you will in retirement, the Traditional IRA is a good choice.

On the other hand, the Roth IRA is not tax-deductible, so the deposits into this type of IRA are not exempted from your total income calculation for tax purposes. In effect, you use “after-tax money” to invest in a Roth IRA. This is a great choice for people who believe their tax rate now will be lower than it will be in retirement once they begin taking distributions.

There are two other benefits to the Roth IRA that often go unnoticed. The Roth IRA does not require distributions after age 70 1/2 like the Traditional IRA, offering more flexibility in retirement. The Roth IRA is better for estate planning; choosing a Roth IRA rather than a Traditional IRA for funds passed onto your heirs will allow them to avoid tax bills.

These benefits come with a drawback: if your MAGI is above $105,000 ($166,000 for those who are married filing jointly) your maximum allowed contribution begins to reduce and will completely phase out at $120,000 ($176,000 for married filing jointly). But there is now a law that will help you get around this for a short time.

In 2010, the $100,000 maximum for Roth IRA conversions will temporarily disappear. If you believe the Roth IRA is a better option for you but you have been prevented from investing in this type of account due to income limitations, now is your chance to make the change. Here is why this will be allowed: When you convert from a Traditional IRA you owe taxes on the amount of the conversion, and the government would really like that income.

If you must pay those taxes using funds from your IRA, the conversion might not be a good idea, but if you have cash saved for the tax bill you will be better off.

You can also convert accounts known as SEP IRAs and SIMPLE IRAs.

Here are some quality resources regarding Roth IRA conversions.

• Schwab Center for Financial Research
• Vanguard
• The Motley Fool

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Roth IRA Conversion

Although I do not have children, I am considering starting to save for college. With the cost of tuition rising well above levels of inflation, the sooner I get started, even before any children exist, the higher the chance my child or children will be able to go to school without an insurmountable pile of debt. Unfortunately, most college savings plans are complicated. They are tax efficient, but only if some conditions are met. If you need to withdraw money from the funds for purposes other than education, you can face penalties. There are a number of variables to consider, least of all is the idea that I may not have children at all.

Kiplinger’s Personal Finance has named its top five 529 college-savings plans to help parents or possible future parents like me decide which options to pursue. None of these options sound perfect, however. I do not like the sound of any of these top five, either due to flexibility or fees. In addition to fees by the dollar, all plans charge a management expense, fees as a percentage of assets, in addition to the underlying funds’ management expense.

Illinois Bright Start College Savings Program. Pros: Low fees. Cons: Low fees only apply to actively-managed funds (poor performers). If you choose Vanguard funds you must pay $10 per fund.

Alaska’s T. Rowe Price College Savings Plan. Pros: Good investment options. Cons: $25 yearly fee for some accounts.

Michigan Education Savings Program. Pros: Plan includes a guaranteed return option. Cons: The plan is run by TIAA-Cref.

College Savings Plan of Nebraska. Pros: Investors can choose from a wide variety of mutual funds. Cons: Every account has a $20 annual maintenance fee.

Virginia CollegeAmerica. Pros: Kiplinger’s counts the fact that this plan is sold by financial advisers as a pro. Cons: The plan includes only funds from American Funds, which are expensive and underperform.

Kiplinger’s also includes a state-by-state guide to 529 plans. Use this guide to determine whether your state offers its own plan with tax benefits. The benefits may compensate for the other drawbacks of the plan. I live in New Jersey, which does not offer any 529 plans with tax benefits, but I could invest with another state’s plan. While I live in New Jersey, I would not be able to benefit in the other state’s tax advantages.

Best 529 College-Savings Plans, Thomas M. Anderson, Kiplinger’s Personal Finance, June 26, 2009

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Kiplinger’s Best 529 College Savings Plans

There is some speculation that Coca-Cola, General Electric, and Wal-Mart are seeking to raise capital by offering stock… in China. The companies have not responded to these rumors, but China seems open to allowing western companies to participate in the country’s stock exchanges once trading resumes.

If American companies want to be on the Shanghai Stock Exchange, American investors might want to be there, too. The way things stand now, it is difficult for foreign investors to participate in the Shanghai Stock Exchange. Any individual investor outside of China must be aligned with a Qualified Foreign Institutional Investor in order to trade companies listed on this exchange.

A more accessible way to access the China stock market may be through mutual funds offered domestically. The Fidelity China Region Fund (FHKCX) is a strong choice despite the 1.11% expense ratio. (Expense ratios will tend to be higher for international funds.) Vanguard does not have a comparable fund, and FHKCX is up 31.25% so far this year.

Funds like FHKCX invest in Chinese companies, and it’s unlikely, if western companies begin trading on the Shanghai Stock Exchange, that these funds will include shares of these western companies in their portfolios. So this doesn’t solve the problem of accessing the shares of these companies that would theoretically be traded in China.

Regardless, if companies see China as an opportunity for growth and capital, it might not hurt to follow them by investing overseas.

Photo credit: SmokingPermitted
Coca-Cola, GE, Wal-Mart May Seek China IPO, UBS Says, Allen Wan and Veronica Navarro Espinosa, Bloomberg, June 17, 2009
Shanghai Stock Exchange, Wikipedia, June 17, 2009

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American Companies May Want to Trade on Shanghai Stock Exchange

Well, I sold my first stock. I agonized over when would be the right time, but then I just pulled the trigger, anyway.

Earlier this year, I started using the “free money” I was getting from this credit card to buy some stocks.

In March, we paid our tax bill of over $3,300 using that card, so the 2% rewards were higher than normal. I asked a friend of mine who knows a lot more about the stock market than me what stocks were catching her eye, and on her unofficial recommendation I bought 60 shares of CAR, the Avis car rental people.

That was April 17th. The stock price was $1.50. With a $9.95 commission at Sharebuilder, I ended up “spending” a total of $99.95.

And then I watched as the stock price just rose and rose and rose.

On about May 20th I started wondering if I should sell my proceeds. We’ve had rather more pet problems than usual and I was a little worried that our upcoming vacation might suffer as a result. The “overall return” on that investment, according to Google Finance, was hovering around 200%, which is a heck of a lot more than the 7 to 9% we’re taught to expect from long-term investments.

So I sold it on May 27th. I was a bit alarmed to see that there was yet another commission of $9.95. To me, that’s like paying a toll over a bridge going in each direction.

Stock proceeds: $282.24
Minus original investment of $99.95: $182.29

Now, if I’m reading this Capital Gains Tax table correctly, we’re going to be hit with a 25% of the “cost basis” come next April. If the cost basis is the amount I spent on the investment, that’d be the $99.95 number again, which means a tax of about $25.

Profit minus upcoming tax: $157.29

So I spent $99.95 and got $157.29, a real profit of 157%. Not the nearly 200% that Google Finance was teasing me with, but not shabby, either.

The other way to look at it is that since the $99.95 was free money in the first place, I made a profit of infinity dollars.

More importantly, when we take our vacation next month, we’ll have $157 that we otherwise wouldn’t have had. That’s one fancy dinner with some very good wine. I’m looking forward to it.

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Smithee’s First Stock Sale