Millionaire Rule #8

Fund a Roth IRA to the Limit
The Roth IRA is my second favorite type of account for retirement saving. Because I'm the type of guy that really gets excited about the prospect of have a massive amount of money in retirement, it means that I REALLY love the Roth IRA. If you are curious what my number one favorite type of account is check out Millionaire Rule #7. My goal for this post is for at least half of those who read it to get fired up and open a Roth IRA in less than 24 hours from reading this post. Now, to explain why a Roth is so great.

First, we have the benefit common to all forms of IRAs, tax free compounding. That means from year to year an investor does not have to pay taxes on the income generated within the account. So for example consider the following sequence of events: you use the money in your IRA to buy some stock, the value of the stock goes up, and then you sell it for a profit. In a normal taxable account when you file your taxes the IRS will want its share of your profits (called capital gains) which can range from 15% (shares held more than a year) up to 35% or the top income tax rate (shares held less than a year). The tax man would also stick his hand out for income generated from dividends and interest (at the top tax rate) as well. Obviously these taxes can be a massive drag on your portfolio except that an IRA keeps the money safe from Uncle Sam.

The money stashed in a Roth is after tax dollars which means you can not deduct your contributions from your income when it is contributed; while on the other hand, a Traditional IRA is tax deductible. This may seem like a bad thing, except to make up for it, when money is withdrawn from the Roth it is tax free. Yep, as amazing as it sounds, all of the money you manage to build up (from both contributions and earnings) in your Roth IRA is completely tax free when withdrawn in retirement. Zero taxes in retirement give the Roth IRA a huge advantage in my retirement planning strategy.

The next great thing about an Roth IRA is that it allows you to shelter more money from taxes than a Traditional IRA. The reason is slightly complex, but here it goes. Both accounts have a maximum contribution in 2008 of $5,000. I already explained how a Roth is after tax income and a Traditional IRA is pretax income that is taxed instead at withdraw. So the effective amount of savings in a Roth that are sheltered from taxes is the full $5000 (post tax) based on an investment of $6666 in pretax dollars. The Traditional IRA can take a $5000 pretax contribution but will only be able to ultimately shelter $3750 because that $5000 gets taxed at withdraw in retirement. If that is confusing keep on reading.

Here is an example, we start with the same $5000 investment and assume the 25% tax bracket both now and in retirement. The Traditional IRA will get a contribution of the full $5000 and then compounds until retirement. At retirement the money is withdrawn and the 25% tax is paid. The Roth will get a contribution of $3570 (remember it is after tax so $5000 * 0.75) and then compounds until retirement where it is tax free. In this scenario both types of account wind up with the exact same amount of spendable cash in retirement (take the tax before or after it is all the same). However, if you have $6666 that you are able to save, you can put the full $5000 into a Roth you will end up with more money tax free in retirement. In effect, the Roth is able to shelter 25% more money from taxes than the Traditional IRA (assuming you have the extra money to save).

Tax rates change over time. Many people believe (and history would seem to support) that current tax rates are well below their normal levels. Many people (myself included) also expect to be in a much higher tax bracket in retirement than they are now. Early in a person's career they may have a lower income coupled with tax deductions for mortgage interest, dependents, and student loan interest that will disappear by retirement time. I expect to go from the 25% tax bracket now to the 35% bracket in retirement (I'm ambitious what can I say?). A Roth IRA protects your retirement income from the risk of higher tax rates in the future. That means a Roth IRA effectively adds 10% on to its value relative to other tax sheltered retirement accounts like a 401(k) or Traditional IRA for someone like me.

The Roth IRA has a few more benefits I just want to quickly address. The contribution maximum is index to inflation so the amount you can save will increase over time. Roth IRAs are given special treatment in the unfortunate even of their owner's death. A non-spouse inheritor can take withdraws from the Roth over the course of their lifetime while maintaining the tax deferral of capital gains and interest. Normally stocks, bonds, or 401(k)s in an estate incur the full tax burden at the time they are inherited (so no continued tax free growth). Lastly, Roth IRAs can be opened with many different banks and brokerages which provide a massive selection of possible investments. Individual stocks, bonds, options, commodities, futures, mutual funds, ETFs, real estate, art and darn near any thing else you can think of can be used an investment in a Roth IRA. This is very different from a 401(k) which is limited to a single management company selected by the employer and only a limited selection of mutual funds in which to invest. Investments in the Roth can cover all asset classes and are completely controlled by the investor.

It may seem like this list could go on and on, but I have one last special benefit of the Roth IRA. Because the contributions to the account are after tax, there are no penalties or taxes from withdrawing your contributions from the account in the event of an emergency. This is very different from a 401(k) where pulling money out before age 59 1/2 would result in paying taxes on the withdraw plus a 10% penalty. The Roth IRA does not have this problem, and it can give you extra piece of mind and a source of cash in a pinch. I really recommend you stay out of your retirement funds if at all possible but at least you know it is there if you need it.

I've covered most of the great benefits of the Roth IRA. In all honesty there aren't many drawbacks. Over 40 years of contributions at the $5,000 and earn an 8% return your account will grow to over $1.4 million. I highly recommend the Roth IRA as Millionaire Rule #8. Check out the rest of the Millionaire Rules and be sure to subscribe to my RSS feed.

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Investing to Beat Inflation!

Today I read an article over at Consumerism Commentary about How to Save a Million Dollars at Any Age. I noticed immediately, and so did several other readers, that $1 million isn't all its cracked up to be 30 or 40 years from now. Inflation is the nasty beast the keeps prices going up year after year. A seemingly tiny 3% annual inflation rate cuts the value of your investment by 326% in 40 years. However, by starting to save early we have one powerful tool to fight inflation, career growth!

It is important to realize that as you progress through your career (and as your salary grows with inflation) the amount you are able to save goes up drastically. Wages tend to increase at a rate that slightly beats the inflation rate. While we don't always get a raise every year, on the whole almost everyone grows their income over time. The trick to beating inflation in your retirement savings is to adjust what you save each year to keep up with inflation. You need to take at least half of any raise you get and use it to increase your retirement savings. For example, if you get a 4% raise, increase your 401(k) contribution by 2% until you get to at least 10% (my goal is 20%). Then once you reach your target rate, in successive years continue to increase the dollar amount so you maintain that percentage.

Example: Lets say you make $40k now at age 25 and save 6% of your salary. Each year during your career you get a 4% raise (matching the average growth of the economy long term). With the first seven raises of your career you bank half of it and keep the other half to spend. Here is what it would look like:

Salary	401(k) Contribution		Income After Saving		401(k) Balance
$40,000.00	$2,400.00		$37,600.00		$2,400.00
$41,600.00	$3,328.00		$38,272.00		$5,920.00
$43,264.00	$4,326.40		$38,937.60		$10,720.00
$44,994.56	$5,399.35		$39,595.21		$16,976.95
$46,794.34	$6,551.21		$40,243.13		$24,886.31
$48,666.12	$7,786.58		$40,879.54		$34,663.79
$50,612.76	$9,110.30		$41,502.46		$46,547.19
$52,637.27	$10,527.45		$42,109.82		$60,798.42
$54,742.76	$10,948.55		$43,794.21		$76,610.85

After doing this eight times you will be savings 20% of your income for retirement and be making $52,742. You will have lost some ground to inflation but not too much.

Here is the great part, if you keep your savings percentage the same over the rest of your 40 year career you will end up with over $3.24 million! Even adjusted for inflation this is roughly equal to $1,000,000 today. You never miss the money you saved either!

If you add into the mix a maxed out Roth IRA this is what your results would look like after 40 years:

Salary	401(k) Balance		Roth Balance
$192,040.83	$3,241,681.40		$1,403,905.20

Total Savings: $4,645,586.60

Income @ 4% Withdraw: $185,823.46

You can draw $185,823 each year in retirement and never touch the principle. This would be more than 96% of your $192,040 pre-retirement salary and equal to about $57,000 today adjusted for inflation.

As you can see, inflation does not have to ruin your hopes of retiring in comfort. Keep this in mind when you get your next raise and you feel the temptation to increase you lifestyle. Lifestyle creep is a far more ugly beast than inflation. Spending more than you make is the sure-fire way to a disappointing retirement.

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Two-Prong Attack: Pay Debt and Invest

I came across an article on CNN Money today that directly speaks directly to my personal finance situation.  Walter Updegrave answers the question of a reader who has $11,000 in credit card debt and $650 per month left in the budget to allocate between debt payment and investing in a Roth IRA. My situation is almost identical, as I too have about $11,000 of "bad debt" that I need to eliminate and $800 per month to allocate.  Walter's answer was, from a strictly numerical perspective, it is generally better to pay the credit cards first.  This is because payment of the debt is the same as an automatic return on investment equal to the interest rate.  To put this in simple terms, if your credit card charges 14% interest your investment must be able to beat that rate (which is not a realistic expectation) for investing to be the better option. 

My situation is slightly different because I have been able to use low rate balance transfers to lower my overall interest rate.  I am paying a little less than 6% on average to carry my debt.  In that case it is fairly reasonable to expect that investing can meet or exceed the return I would gain from paying my debt first.  My current spending plan however is to do both in a two-prong solution. 

I pay $600 per month toward my debt (roughly double the minimum payments) and $200 per month toward my Roth IRA.   This will allow me to start working toward my retirement goals and pay my debt on at accelerated pace.  When I get my next raise in mid-to-late 2008 I will further increase my Roth contributions up to the $5,500 per year maximum.  A Roth IRA provides a potential source of cash (contributions can be withdrawn at any time for any reason without penalty) and future tax advantages as I'm nearly certain my tax bracket will increase in the future.  Having a Roth to tap may also keep me from running up debt at a higher interest rate in the event of an absolute emergency further down the road. 

The article also begins to discuss the psychological issues of debt spending.  It is all too common for a person to take a few steps in the right direction only to take two steps back as the run up new debt.  By attacking both goals you can move forward even if your debt balance stays maxed out.  I hope that this blog and the publication of my financial results will keep me from falling into this trap, but it is an important point to make.

Today I was included in the Carnival of Personal Finance #134.   MrsMicah did a great job hosting, and provided some nice commentary with her Editor's Picks.  It is one of my goals for 2008 to have one of my posts selected as an Editor's Pick.  The article that got me most fired up was by Lily at The Honest Dollar called In Defense of Personal Finance Bloggers.  I like to think of myself as a blogger who is not obsessed with retirement (which is what the article is all about), hopefully I don't come across as that type.  I don't care for possessions or having "things" but I do value experiences like traveling, hosting parties, and eating at nice restaurants.  These are things best enjoyed while I am young so I can enjoy the memories for an entire lifetime. 

However, I AM actually obsessed with making the most of the money I have; which means getting rid of debt, investing for growth, and spending money wisely.  I also recognize that the lifestyle I truly desire is well beyond my current means, so instead I will live below my means (which is even farther below my desired lifestyle) in order to build wealth so I can life that lifestyle "one day."   I want to live in a house with a dedicated home theater, drive a luxury car, and take month long vacations to the Mediterranean.   This is not possible with a household income of $80k but it WILL be possible when I am 50 and have an income of $200k with a couple million in the bank.  So for now I will forgo the $4k beautiful 60" 1080p plasma television I drool over in the store and instead buy the 37" 720p LCD television that I got on sale for $620.  For vacations, my wife and I do things like rent a cabin with friends for a long weekend or meet my family at a rented condo at the beach instead of a fancy cruise or European jaunt.  That is by no stretch of the imagination frugal like how some other personal finance bloggers live their lives, but it will still enable me to save 16% of my gross income in a Roth and 401(k) and have some fun too. 

I guess I see spending and saving, paying debt and investing, hard work and playing hard, etc as parts of our lives that need to be balanced in order to get the most out of the years we've got.  Readers, please call me on this if you see me spouting non-sense or acting hypocritically. 

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Inside My Portfolio

This blog is all about my path to wealth so it is about time I shared the full details of how I invest. In future posts I will add more information, but for now all you need to know is that I am working to have a fully diversified collection of index funds known as a lazy portfolio. Comments and questions are welcomed and encouraged. Subscribe to my RSS and check back to learn more about my investing philosophy which I think is my best opportunity to build wealth.

Personal Investment Employer Contribution Roth IRA $2,600 401(k) $6,176 $3,860 Holdings Ideal Allocation Current Allocation Description Roth IRA SWERX NA 5.26% Schwab Target 2040 401(k) VFINX 30% 31.20% Vanguard 500 Index VEXMX 10% 13.36% Vanguard Extended Market VFWIX 40% 37.55% Vanguard FTSE All-World ex-US VBMFX 5% 7.42% Vanguard Total Bond VSGBX 3% 5.20% Vanguard Short-Term Federal Other 12% 0% Emerging Markets, REIT, Gold, ...

A little explaination may be needed. First, my Schwab 2040 Fund is not a part of my ideal asset allocation strategy. It is a temporary account until I have built up enough money to meet the minimum account balances required for my REIT, Emerging Markets, and Commodities funds I want to hold at Vanguard. I selected Schwab for this because it was very friendly to those with small amounts to invest (no account fees, $100 to start, and $100 per contribution). Second, I do not exactly hold the Vanguard funds I list as my 401(k) holdings. The funds I actually hold are not open to the public but track the exact same index and have a similar expense ratio to the Vanguard funds. For all intents and purposes they perform identically. Also, my allocation is slightly off in my 401(k) because I am unable to directly buy my "ideal allocation" due to purchase minimums (and other logistical problems) so I have to move around my new money to move toward the right balance. Over time as the amount of my new contributions becomes a smaller percentage of the account balance I will move closer and closer to my ideal allocation. Finally, I would do an all out rebalance of my account if it strays more than 5% from my ideal (this has not happened yet due to how I use new money to do mini-reblancing bi-weekly).

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One Fund Investing

I recently opened my Roth IRA with a brokerage firm and now hold a fully diversified portfolio contained in a single fund called a Target Date Fund. I started with a balance of ZERO and have resolved myself to save $100 per paycheck (bi-weekly) with an automatic withdraw. When I was selecting the brokerage my first priority was to find one that had low minimum investment ($100) and low minimum deposits (again $100). I was also looking for access to a wide array of index funds. I am a convert to the passive investment style based on a number of great books, academic papers, and blog articles that I've read. I suggest starting with Are Index Funds the Best Investment? over at Get Rich Slowly or Walter Updegrave's CNNMoney columns.

Considering these factors, I opened my account with Charles Schwab. Once I have saved enough to create a diversified portfolio of index funds with Vanguard I will likely move my money in order to have access to funds with even lower expense ratios. So far I have been relatively happy with my choice but at this point it has only been two months. I'll write a follow up with my results and a review of Charles Schwab as a brokerage after I've been there for a while longer.

When I selected the fund to invest in I ended up choosing a Target Date Fund to hold. I put my money into the Schwab 2040 Target Fund (SWERX). The fund offers me a nearly complete diversified portfolio holding cash, bonds, foreign and domestic stock, large and small cap stock, growth and value, and real estate. I like that I can hold ONE FUND with low minimums and have exposure to nearly all of the asset classes I need. After reading the full fund prospectus from Schwab and looking at the asset allocation breakdown they provide, there are a few issues I've found. First, it is not a true index fund. Some of its holdings do use active management or deviate more than I would like from their target index. The 2040 Fund also holds more cash (6.63%) and more bonds (9.35%) than I need for my 38 year time horizon. I would also prefer a small amount of exposure to commodities and inflation protected bonds. My final gripe is that the expense ratio is 0.94% which is higher than an equivalent fund from Vanguard or Fidelity (but is still lower than 75% of its peers).

All in all I'm happy with my Roth IRA selection. Check back regularly to read more about my investment decisions and investment results as I... Aspire 2 Wealth!

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Back to the Grind

I am back from my Holiday travels. The entire trip consisted of three things: 1) Driving, 2) Eating, and 3) Football. My wife and I had a good time visiting her family, and I'd say the trip was a success.

During the trip I was asked several times what my plans are for the future. That got me thinking that I don't really have a cohesive plan for the next phase of my life. I've reached a point where most of my short term goals like completing my masters degree and buying a house have been achieved. What do I do next?

I might get a Ph.D. It can almost never hurt to get more education (especially when my work contributes to these endeavors) and it would be really neat to be Dr. Adfecto! I have also thought about becoming a Certified Financial Planner. Why not make my favorite hobby into my day job? I might actually enjoy my work that way. I have also looked into becoming an entrepreneur by starting businesses in a few different fields; 1) real estate investing, 2) real estate property management, 3) franchise (Subway, Papa Johns, etc), 4) home theater/networking/automation/AV installer, and 5) financial services firm. I can already see the glass ceiling above me at my current job (though I have a few years before I hit it) so I want to be prepared to maximize my earning potential.

Another thing I thought about a lot over the last few days is my near term financial goals. I'd like to put them down here to document my thoughts and outline the specifics. First, I want to pay off all of my debt except my mortgage. That is my most immediate goal and I think is a great goal that everyone should achieve. I currently have about a 12k car loan and about 12k in consumer debt that I want to pay off. I also want to reach a savings level that maxes my Roth IRA ($5500/year) and puts me on course to max my 401k (15% of gross pay). Next I want to purchase (preferably with cash) a replacement for my 1999 Chevy sedan that is sadly already struggling. Third, I want to establish an emergency fund with > 3 months of expenses in an online savings account. I have set a very ambitious completion date of July 1, 2010.

This is the basic advice that the columnists like Walter Updegrave (CNNMoney), Michelle Singletary (Washington Post), and Liz Pulliam Weston (MSN Money) or the gurus like Dave Ramsey (The Total Money Makeover), Robert Kiyosake (Rich Dad, Poor Dad), and David Bach (The Automatic Millionaire) or the scores of personal finance bloggers (Money Blog Network) write about every day. I agree with them and will put these goals into practice in my life. Reading these articles and books is a great start however, is not enough to bring out the type of wealth I want in my life. I want to be able to travel to exotic places, to own a beautiful spacious home (or two) with upgrades like a home theater and billiards room, own a pair of late model mid-luxury cars (for example Infinity G35 for me and an FX35 for my wife). I want be able to work with flexibility and generate as much of my money as possible from completely passive sources (bonds, stocks, 3rd party managed real estate or businesses, etc). In other words, I want to be truly wealthy with a net worth of 10-15 million. That my friends is not the 'Millionaire Next Door' or the 'Comfortable Retiree' that will result from the advice of those I mention before. What then should I do to achieve this kind of wealth that such a small percent of Americans achieve? That is a whole different set of ambitious goals I need to figure out.

Aspire 2 Wealth is a center piece of this thinking. It will provide me a place to put my thoughts into concrete form so my ideas don't go to waste. It will also (hopefully, one day soon) give me an audience (or even better, a community) to give me feedback, encouragement, and tough love to push me further toward my goals. I think I need someone to call me on my pie-in-the-sky dreams and make me take action on the dozens of "million dollar ideas" I think I have on a regular basis. Thoughts and suggestions appreciated.

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