Personal Finance Cafe

Rolling over a 401k

2005-09-10T07:54:00.000-07:00

When it comes time to change jobs, it is easy to get caught up in the excitement of the job search and starting a new job. If you have money in your 401k, it is very important that you don’t forget about it and continue to have this money work for you for its intended purpose: your retirement.

It is very tempting when leaving a job to have the amount in the 401k paid out to you to spend now. If you are under 59 ½, than you will be subject to a 10% penalty, as well as having to pay income tax on it. This is worse than never putting money into your 401k at all. If you have $5,000 and take it in cash, you will get $4,500 after the penalty, plus pay income tax (assume 25%), for a net of $3,375. If you left it in your 401k and have 30 years until retirement, it will be worth about $50,000 (assuming 8% annual return). It is certainly worth giving up $3,375 now to have an extra $50,000 at retirement.

One choice you have is to roll your 401k into an IRA. Your plan administrator will be able to give you instructions on how to do this. If you have enough (usually over $5,000) in your 401k, they may allow you to keep it in the 401k, but you will likely have to pay some annual fees. You will likely have many jobs in your lifetime, so I would rather have one large IRA to manage than several smaller 401k accounts held at different institutions. To help centralize your retirement and avoid fees, I am a strong proponent of rolling your 401k into an IRA.

Points on a Mortgage

2005-09-06T21:57:00.000-07:00

When you are choosing a home mortgage, you have the option of paying points (one point is equal to one percent of the loan amount) in order to reduce the interest rate, and therefore, reduce the monthly payments. I have found that this is rarely a good idea.

Basically, you are paying now for a return on your investment (points paid) over time. Unfortunately, it is hard to determine how long you will have the loan. Let’s look at an example. Assume you are borrowing $300,000 for 30 years at a fixed rate and you can have an interest rate of 5.625% with no points or 5.375% with one point. The one point will cost you $3,000 (1% of $300,000). Your payments with the no points loan are $1,726.97 per month and the payments with the one point loan are $1,679.92, for a reduction of $47.05 per month.

In order to recoup the $3,000 you paid for your point, you must hold the loan for 63.76 months ($3,000/$47.05). You must also note that this does not take into account the time value of money, as you paid the $3,000 now and received the benefit over time. If you take into account the time value of money and assume you could get a 6% annual return on the $3,000, it will take you about 77 months to recoup the point. Many people look at this and think that because it is a 30-year loan and the point pays itself back after about 5 years, than it is a smart move. However, most people do not hold onto the loan for the full 30 years. If you sell the home or refinance before the 5 years is up, you will have lost some of the money you paid in points. Because the opportunity to refinance may arise if rates drop, you can never be certain you will hold the loan for the 5 years. Additionally, by paying points, you make it less likely that you will be able to refinance and save. In our example, if you chose to not pay points and got the 5.625% loan and rates dropped to 5.375%, you could probably refinance (assuming low closing costs) and save money. If you had paid points, you would stick with your loan and not be able to reduce your payments. I believe that people should save their money and stop paying points.

Budgeting 101

2005-08-28T10:47:00.000-07:00

If you don’t know where you are going, any road will take you there. – Louis Carroll

In personal finance, as in almost anything, it is extremely important to have goals. Your financial goals may include purchasing a home, retiring at 55, or paying for your children’s education. Your budget should be your map to these goals.

I suggest developing a budget that includes a high level of detail for the next year and has high level information for the next four years. This will allow you to have a good idea of where you are headed in the next five years. First, write out some goals and do any calculations necessary to figure out what you need to do now to achieve them. For the goal of wanting to retire by 55, your plan may be to fully fund your Roth IRA every year and max out your 401k contributions. With these in mind, start by writing down all of your income and expenses (I suggest using Excel). As part of this exercise, it is a good idea to do a rough calculation of your taxes. This will allow you to plan your taxes for the next year and possibly adjust your withholdings. I am a strong believer that the amount of taxes owed or the refund you receive should not be a surprise in April.

As you map out all of your expenses, look back at past checkbook entries and credit card bills to get a realistic view of what you spend. Make sure to allow some cushion for unexpected expenses such as auto repair. You should not only budget your revenue and expenses but your balance sheet items as well. This would include your cash balance, investments, 401k balance, and liabilities such as your mortgage balance or car loan balance. This is a good idea as you may not see your cash increasing every month, but you may be lowering your liabilities (paying off debt) or increasing your assets (buying a car or home and funding your retirement accounts).

After you have a budget, track your actual expenses against it. This is very valuable, as you will often learn that you are spending more than you thought on a few items. It is very common to be surprised at how much you spend on eating out. After a few months, you may want to adjust your budget so you get a more realistic view of where you are heading.

Standard Deduction versus Itemized Deductions

2005-08-27T15:35:00.000-07:00

I often hear people say about charitable contributions “it is tax deductible.” Unfortunately, many of the people saying this don’t have enough deductions to itemize, so the donation is not really deductible to them.

In order to itemize your deduction, you must fill at Schedule A on your tax return. The majority the deductions usually come from mortgage interest, real estate tax, state income tax (and know sales tax if it is greater than state tax), auto registration, charitable deductions, medical expenses (limits apply), and unreimbursed business expenses. It doesn’t make sense to itemize unless these deductions in total exceed the standard deduction.

In states with high tax rates such as California, a single person may pay enough in state taxes alone to exceed the standard deduction. You should understand your situation and know if you are likely to itemize or take the standard deduction. I am not saying you shouldn’t make a charitable donation if you don’t itemize, just know that you won’t be getting a deduction for it. Also, if you don’t itemize this year but will likely itemize next year (do to higher state taxes, purchasing a home, etc.), you may want to push back the donation until next year to be able to deduct it.

Retirement Portfolio

2005-08-25T19:18:00.000-07:00

Because I work in Finance, friends and co-workers often approach me when it comes time to fill out their 401(K) allocation form. Although there is no simple answer, there are some rules of thumb financial advisors use. Basically, there are two major principles that need to be applied. First, the closer you get to retirement, the less risk you want in your portfolio. Second, a good portfolio is a diversified portfolio, with a range of stocks (small cap, large cap, international, etc.) and bonds.

If you are about 35 years from retirement, it is recommended you have about 70% of your portfolio in domestic equity, 15% in international equity, 10% in high yield fixed income, and 5% in investment grade fixed income.

If you are about 25 years from retirement, it is recommended you have about 70% of your portfolio in domestic equity, 12% in international equity, 8% in high yield fixed income, and 10% in investment grade fixed income.

If you are about 15 years from retirement, it is recommended you have about 60% of your portfolio in domestic equity, 10% in international equity, 8% in high yield fixed income, and 22% in investment grade fixed income.

If you are about 5 years from retirement, it is recommended you have about 40% of your portfolio in domestic equity, 5% in international equity, 8% in high yield fixed income, 40% in investment grade fixed income, and 5% in short-term (money-market, CDs, etc).

As you can see, as you approach retirement it is necessary to reduce your risk. With the domestic equity, a similar pattern should be followed. When you have a long time until retirement, you can afford higher-risk equity such as small-cap stocks. As you approach retirement, the percentage of your portfolio in small-cap stocks should decrease and the amount in large-cap, dividend producing stocks should increase.

Choosing a Mutual Fund

2005-08-23T17:46:00.000-07:00

Most people don’t have the time and expertise to buy individual stocks and bonds, so they turn to mutual funds. If you have ever looked at the list of mutual funds available, it is a daunting list that grows every year. Friends often ask me how to choose a mutual fund that is right for them. Here are some simple rules to following when searching for the right fund:

Align with goals In choosing a mutual fund, you must first figure out what your objective is. You may be looking for one fund to act as you entire portfolio, or you may be looking to add a mutual fund in a certain sector to help diversify your current portfolio. Adding a duplicate mutual fund (one that has the same characteristics of a fund you already own) and buying high risk funds that are not aligned with your goals are common mistakes made.

Don’t chase top performers The stock market very cyclical in nature. People often look at which funds were the most successful in the past year and jump on the bandwagon. Unfortunately, last year’s top performers are rarely the top performers the following year. You want to make sure you pick a fund that is consistent, so look at the 3, 5, and 10 (if applicable) year performances. You may also want to look at how the fund did in each of the years to make sure that most of the return was not just from one great year.

Compare returns to a benchmark People often say things like “Wow, this fund went up 15% last year” or “My fund only went up 2%.” You need a point of reference to evaluate this performance. If the fund went up 15% and the stock market went up as a whole by 30%, the 15% is not too good. If you fund went up 2% while the market went down 5%, that is a good performance. You will want to select an appropriate benchmark such as the S&P 500 for large growth funds or the Russell 2000 Index for small growth funds. If you use an online database to look at the fund such as Yahoo! Finance, they will usually provide the appropriate benchmark.

Look at the management teams tenure Often the performance of a mutual fund is due to a strong management team. You may look at the past 5 years performance and see that it is a top performing fund, however, the management of the fund may have changed recently. Make sure that the fund you are investing in has strong performance history with the current portfolio managers. Peter Lynch is considered one of the great stock pickers of the 20th century. He managed Fidelity Magellan to years of outperforming the market and Fidelity Magellan became the largest mutual fund based on dollars invested. Once he retired from the fund, people continued to invest in it, but the performance was never the same.

Minimize Fees Great performance is only great if you get to keep most of the money. Funds have fees in the form of loads, commissions, expenses, and 12b-1 fees. Make sure to take all of these into account when evaluating a fund and try to look at past returns both before and after fees and expenses.

Stock Recommendations 1

2005-08-21T18:39:00.000-07:00

Being in Finance, I am often approached about stock recommendations. I do follow the stock market, and from time-to-time I will make some recommendations on this site. Today I would like to recommend three stocks, two in the oil industry and one in real estate.

The first is Exxon Mobil (XOM). I believe the price of oil is not going to drop any time soon. There is plenty of demand, particularly with China adding significantly to world demand. As far as supply, the obvious problems in the Middle East as well as the tight control of OPEC are limiting supply. Additionally, we have an oil-friendly government right now that is not doing much to combat rising prices. With all of these factors taking place, I would expect strong growth in the oil industry. Exxon Mobil is a strong company and is a good company to invest in as a proxy for the industry. Currently, it trades at about $60 a share, with a P/E of 13 and a nice yield of 2.39%.

Chevron (CVX) is another strong player in the oil industry. The company has done a lot in recent years to clean up its balance sheet and they have recently agreed to acquire Unocal. This acquisition should allow them to run even more efficiently and should help them compete with Exxon Mobil. Chevron is currently trading around $60 a share, with a P/E of 9.7 and a yield of 2.86%.

My last pick goes to Capital Title Group (CTGI). CTGI provides title, appraisal, and other transaction services to the real estate and mortgage lending industries. This company has revenues of about $350 million, EBITDA of $40 million and cash of over $20 million. The P/E ratio is 10 and the PEG ratio is 0.65 (the PEG ratio is P/E divided by estimated 5-year growth rate. Less than 1.0 is generally considered under-valued). The stock currently trades for around $7.50 a share.

Federal Tax Withholdings

2005-08-20T10:52:00.000-07:00

I am often asked how to choose how many exemptions to select when filling out a W-4. The first part of the answer is to explain how this works. As you enter more exemptions, the amount withheld from each paycheck decreases, thus increasing your net check. The IRS then receives this money and you get credit for paying it when you fill out your 1040. A lot of people feel their accountant (or they) did a good job filling out your tax return if they get a large refund. In actuality, they merely paid the IRS too much over the course of the year. Theoretically, it is better to get as much money as you can throughout the year and get no refund or have to pay the IRS. This is true because you can earn a return, either interest or gains on stocks, while you have the money. However, a lot of people feel they will not feel the slight increase in each paycheck and would rather get the refund in a lump some at the end of the year. Others lack discipline, and will spend the money throughout the year and will not have it if they owe taxes when they file. You have to decide which boat you are in to decide if you should maximize your paycheck throughout the year, or over-withhold and get a refund.

The IRS is not okay with you not paying them anything throughout the year and then paying it all when you file your return. If you do not withhold enough throughout the year, the IRS will charge you a penalty when you file your return. If your adjusted gross income is under $150,000, you will not have to pay an underpayment penalty as long as your tax paid throughout the year is 90% of the current year’s tax or 100% of the prior year’s tax. If your adjusted gross income is over $150,000, you will not have to pay an underpayment penalty as long as your tax paid throughout the year is 90% of the current year’s tax or 110% of the prior year’s tax.

The IRS provides a calculator to help you calculate how many exemptions you should select. This is especially helpful if your situation changes mid year (such as a large raise or going from unemployed to employed). I strongly recommend you review your withholding amount every year.

How much should you spend on a house?

2005-08-18T18:29:00.000-07:00

A reader submitted the following question:

The nationally suggested portion of your monthly income to spend on your mortgage payment is around 30-35%. This isn't very realistic in places like California where housing prices are exorbitantly high. What do you think is a reasonable amount to spend when purchasing a home in these situations?

This is a great question and one that arises for every first-time homebuyer. As real estate has appreciated so rapidly in the past few years, many people who don’t own are struggling to afford their first home. The first part of the answer is to find out how much you can borrow. The rule of thumb is that a bank does not want your payments to exceed 40% of your gross pay. The bank looks at your total monthly payments for all loans including the home loan as well as auto loans, school loans, etc. plus the real estate tax payments you will have to make as well as insurance payments and divides this amount by your monthly gross income. You can talk to a bank to get pre-qualified and work with the bank on the maximum they would be willing to loan you.

The second part of the answer is to figure out what you can afford, not necessarily what the bank is willing to loan. Not everyone making the same amount of money spends the same amount on clothes, entertainment, gas, etc., but the fact that banks use of one ratio for everyone suggests otherwise. Additionally, your cost of living does not go up dollar for dollar as your gross income increases. For example, you may pay $45 for cable today, but if your income were to double tomorrow, your cable would still be $45. Likewise, many other expenses stay constant or grow more slowly than your income.

First, I suggest analyzing your situation. Is your income likely to grow (promotions, etc.), stay steady, or decline (possibly work fewer hours due the birth of a child) over the next several years? Are expenses likely to change significantly in the future, perhaps to do childcare expenses or the expense of caring for an aging parent? You should then sit down and write out a multi-year budget and play around with various home prices (I highly recommend Excel for this). It is extremely important that you look at the tax benefit of the purchase, so I recommend estimating your taxes and take into account the deduction for mortgage interest and real estate tax. It is extremely important that you be honest with yourself and accurately estimate your expenses. You also don’t want to be able to afford the house based on an assumption of a big raise or some other event that is not guaranteed. Make sure you have money remaining at the end of each month, as you want the cushion and may have unexpected expenses (such as unforeseen medical expenses or auto repairs).

Buying a home is a highly leveraged investment. By taking on more than you can afford, you are putting yourself in a precarious situation. However, keep in mind that you do want to stretch a bit, because the closing costs on a home are expensive. You don’t want to purchase a home and then want to move to a nicer home in a year or two. Finding the right balance is up to the individual and how much risk they are comfortable bearing.

Last, I don’t recommend taking on a variable loan just to allow you to afford a place. No one can accurately predict interest rates, so you don’t want to be forced out of your home if they change significantly and your payments jumps higher.

What closing costs can I expect when I purchase a home?

2005-08-17T18:54:00.000-07:00

A question came in from a reader asking how much to expect to pay in addition to the purchase price of a home. This is a great question. Often people use up a lot of their money to come up with the down payment on a home, then get the final closing statement and realize they are responsible for a lot more costs.

First, the good news. When you use a realtor to purchase a home, the realtor’s commission is paid by the seller. This is a very big expense, but thankfully, the burden is on the seller of the home, not the buyer.

During escrow, you will want to hire an inspector who will look at the property and write up a report for you detailing the findings. This is a very important step, but this service is very valuable for several reasons. First, if you purchase the home and find a major problem shortly after that the inspector should have found, the inspector may be liable for the damage as well as possibly the seller. Second, the list of problems the inspector finds may be minor, but you may be able to negotiate further with the seller such as “I didn’t realize there was a crack in the bathroom mirror, how about you fix it or give me $100 at closing to do it myself.” If you are able to do this over a few minor defects, you may make more than enough to cover the expense of the inspector. Third, you may find a major defect such as a broken furnace, a leaky roof, or mold. Finding this during escrow can lead you to have the seller fix the problem or to get out of the deal entirely.

It is smart to ask your realtor or other people you know who have purchased a house recently for recommendations on a good inspector. When you ask, you can get a good idea of the cost. Make sure the inspector is part of NACHI (The National Association of Certified Home Inspectors). The first factor for the cost is whether it is a house or condo. An inspection of a house is more expensive as it involves inspecting the outside (including the roof and under the house) as well as the inside. The inspection of a condo only includes the inside of the condo since the roof and outside of the building is the responsibility of the homeowner’s association. The next factor is obviously size. Since it is much easier to inspect an 800 square foot one-bedroom house than a 3,000 square foot four-bedroom house, size will drive cost. A house with a pool is also more expensive to inspect and the age of the property and the type of foundation will also determine the cost. As for actual cost, a condo should run a few hundred dollars ($200-$300) while a house will likely be $300 and up depending on the factors mentioned above. It should be noted that this is an expense your bear whether or not you close escrow. If you end up not buying, either because of the inspection or any other reason, you will not be refunded for the inspection. Also, you pay the inspector directly; this is not part of the escrow/closing statement process.

When you close, you will pay prorated amounts for the mortgage and property taxes. Additionally, you will have a long list of fees on your closing statement. I recommend going to E-Trade’s site to get a quote. When you do this, you can see an estimate of some of the closing costs. Some of the larger fees are the escrow fee that can range from $500 to $2,000 and up and title insurance that can range from $400 to $1,500 and up, depending on the price of the home. There are several other fees such as notary charges for signing documents, loan fees, recording fees, appraisal fees, and messenger fees. The loan originator and the escrow company should be able to give you a detailed list of the estimated fees once you start the process. These fees can range greatly depending on the price of the home and the loan originator used. I recommend budgeting 1% to 2% of the purchase price for closing costs.

Why the concern over oil prices?

2005-08-16T19:41:00.000-07:00

The news headlines lately have been filled with talk about rising oil prices. Over the past several weeks, oil has hit record highs as talk of high demand and terrorist threats in Saudi Arabia have driven up prices. Not only does this force you to pay more at the pump, it also affects the economy more broadly.

Companies that make goods and ship goods are greatly affected as their costs can skyrocket as oil prices increase. Ultimately, much of the increases get passed on to the consumer. This will result in you seeing higher prices at the grocery store, at Wal-Mart, etc. Because it now costs more to live, this drives inflation. In order to mitigate inflationary pressures, the Fed may raise interest rates. Rising interest rates make for a tougher environment for companies to succeed (due to their cost of capital increasing), and therefore, a tougher environment to make money in the stock market.

As an investor, you must be aware of these impacts. Industries negatively impacted by rising oil prices are obviously those who consume a lot of oil. These include travel (airlines, cruise companies, etc.), shipping companies and companies that ship a lot of their goods (such as grocery stores and Wal-Mart, which ship there good all over the world). A diversified portfolio will allow you to soften a lot of these bumps and make your portfolio less volatile to changes in oil prices. I recommend purchasing companies in the energy sector such as Exxon-Mobil (symbol XOM) or purchasing a mutual fund that specializing in the energy sector such as ICON Energy Fund (symbol ICENX). Unless you want to make a big bet on oil prices continuing to rise, I wouldn’t have your portfolio have more than ten percent invested in this sector.

The Rule of 72

2005-08-15T22:49:00.000-07:00

A nice shortcut that can be used in quick financial calculations is “the Rule of 72.” To find out how long it will take for an amount of money to double at a set rate of return, divide the rate of return (treated as a whole number and not a decimal, for example, 8% is 8, not 0.08) into 72. For example, if you have $100 and expect to make 8% annually on it, it will double to $200 in 9 years (72/8). If you only expect to return 6% annually, it will take 12 years.

If you are 30 years old and have $50,000 in a 401K which you hope will return 8% annually, that $50,000 will grow to about $800,000 by the time you are 66 (it will double every 9 years, so it will double 4 times in 36 years).

Introduction

2005-08-14T16:42:00.000-07:00

The goal of this website is to create a forum where I can address frequently asked questions and help simplify the world of personal finance. I will be drawing from my personal experiences, my education and job experience (I am a CPA and have an MBA in Finance), as well as using other sources. I plan on addressing a broad range of topics including investing, taxes, home ownership, insurance, budgeting, and savings.

Please feel free to comment on any of my articles or e-mail me with any questions or suggestions you may have. I would like to make this a forum of ideas rather than a monologue, and I will do my best to evolve this website to best suite the readership.