Dear Liz: I just started saving for retirement through my job’s 401(k) plan. I’ve been putting aside $400 a month. I just checked my account to see how it was doing. It has lost over $600! I am trying to save for my retirement — not lose. Where should I invest? I’m considering getting a financial planner to help me.
Answer: The most important thing you need to know about investing is that there is no such thing as a truly risk-free investment.
You won’t lose your principal if you invest in “safe” investments, such as Treasuries and FDIC-insured bank accounts. But you won’t earn enough to keep ahead of inflation. Basically, you’ll never be able to save enough to retire, since the purchasing power of your funds will erode over time rather than grow.
To stay ahead of inflation, you need to take more risk. Stocks over time have consistently offered returns that beat inflation. In every 30-year period starting in 1928, stocks have returned average annual returns of at least 8%. But they certainly don’t gain that much every year, and some years you’ll face steep losses. When you invest in stocks, you have to be prepared for volatility. In other words, sometimes your investments will lose money.
You can reduce that volatility somewhat by diversifying your stock investments (some small companies, some large; some U.S. companies, some foreign) and by including a diversified mix of bonds in your portfolio, along with cash.
A fee-only financial planner can help you design an investment plan that makes sense for your situation. Or you can consider opting for the “lifestyle” or “target date retirement” funds offered by your plan, since they do the diversification and rebalancing for you.
Dear Liz: Is there a reason not to panic? I see my investments tumbling and I am already very conservative. I don’t want to put it all under the mattress, but what else can a person do to hang on to what I have saved? I am fast approaching retirement age.
Answer: If you’re prone to panic, you should turn off the television pundits who like to scare people, which seems to be most of them.
What you need are perspective and balance. If you’re within 10 years of retirement, you should invest in a session with a fee-only financial planner to make sure your portfolio is appropriately diversified. Taking too little risk can be as dangerous as taking too much when you have a 20-year (or longer) retirement horizon.
Over time, the stock market does march upward, although it’s never a smooth path.
Dear Liz: You recently advised a couple who were in sound financial shape about possibly refinancing their home loan to a lower interest rate. You suggested a 15-year loan to make sure they entered retirement without a mortgage. Why not recommend getting a 30-year loan to get the lowest required monthly payment, then making extra payments to get the loan paid off faster? This approach offers the flexibility of being able to drop back to the lower payment in the event of a job loss or other financial setback. They sounded like well-disciplined people and probably could turn that 30-year loan into a 15-year loan by paying 13 payments a year instead of 12.
Answer: Refinancing to a 30-year loan can certainly make sense for people who want to lock in the lowest payment and maintain their financial flexibility in the face of possible financial setbacks. You’re also right that this couple seems disciplined enough to make the extra payments to get the loan retired before they do.
However, you missed a key factor: This well-disciplined couple had a mortgage with an interest rate of 5.875%. That indicates they’ve had this mortgage for a while. If they’ve paid down enough of the principal balance, they may be able to refinance to a 15-year loan with a significantly lower interest rate (as in slightly over 3%) without dramatically raising their payments. Many people, when faced with that option, would want to lock in the lower rate.
Dear Liz: My husband and I are in our late 40s. My husband is the sole provider. We have $200,000 equity in our home and a 5.875% interest on our mortgage. We have nine months’ worth of expenses saved in an emergency fund, plus we contribute $100 a month to our son’s college fund and 6% to my husband’s 401(k). We make regular monthly payments on a student loan balance of $12,000 (at 4.167% interest) and a personal loan balance of $12,000 (at 0%). My husband has had two stretches of unemployment over the last five years, each lasting for about six months. We have begun saving in a secondary account and are uncertain how to best use that money. Should we pay off the student loan? The mortgage? Invest in a CD or IRA? Or consider some other investment strategy?
Answer: You don’t say how much is in your husband’s 401(k), but a 6% contribution rate when you’re in your late 40s is unlikely to generate a big-enough nest egg to retire. Boosting that contribution rate should be your priority, and you should consider contributing to a Roth IRA for each of you.
Likewise, saving anything for your child’s college education is smart, but $100 a month won’t get you far. Just for comparison, consider that parents of newborns need to save around $600 a month to pay the full cost of a public college. Those who start later or want to cover a private college have to contribute much more.
Most families aren’t able to save that much, so the next best thing is to simply save what you can — after you’re fully on track with your retirement savings.
You shouldn’t prioritize paying down your relatively low-rate debts over these two far more important goals. But you may want to consider refinancing your mortgage to dramatically lower your rate and perhaps free up more cash for your goals. Just try to make sure the loan will be paid off by the time you plan to retire. A 15-year loan, in other words, might make more sense than refinancing into another 30-year mortgage.
Dear Liz: My husband is 30 and I’m 28. We were told the importance of contributing to our retirements and so now have $58,000 saved. We have an additional $65,000 saved for a down payment. Due to my son’s recent liver transplant, I won’t be able to work for an indefinite amount of time, so we are reduced to one income of about $60,000. We have to move to get into a better school district and can’t decide what to do. We’re currently looking at homes in the $200,000-to-$250,000 range. My husband wants to use my $38,000 retirement savings (which would be $30,000 once taxed) to get into a home with a lower payment that will not require me to work. I’m scared to do this since everyone preaches retirement, but at this rate we won’t have a mortgage when we retire. Plus, who wants to be a millionaire at 60! I want to enjoy life while we’re young and our kids are young. We are very disciplined but just don’t know what to do. Thanks!
Answer: You can enjoy life and still refrain from doing stupid things that will jeopardize your retirement.
And tapping retirement funds early is typically pretty stupid. You’re giving up all the future tax-deferred returns that money could have earned. By the time you’re 60, that $38,000 could have grown to nearly $450,000.
You also may be underestimating the tax bite. You can withdraw up to $10,000 from an individual retirement account for a first-time home purchase, but the remainder of the withdrawal will be penalized at a 10% federal rate, plus whatever penalty your state assesses. The entire withdrawal will be taxed at your current income tax rates.
The taxes and penalties are substantial for a reason: You’re supposed to leave this money alone. Since you probably won’t be able to contribute to a retirement account for a while, it’s even more important not to squander these funds.
Besides, the extra $30,000 would lower your monthly payment by about $160 on a 30-year fixed-rate mortgage at 5%. That doesn’t seem like much of a payoff considering what you’d be giving up.
Dear Liz: I’m 55 and single with no dependents. I have about $250,000 invested. I rent an apartment in Los Angeles. I work in sales, which I can do anywhere. Would I be better off buying a house for about $150,000 now (somewhere in the middle of the country), thus reducing my living expenses (property tax and insurance will cost much less than rent) and leaving me with about $100,000 left for retirement, or just continuing to invest the entire $250,000 for retirement?
Answer: Moving to a less costly part of the country is a time-honored way to make your money stretch further in retirement. It also can help you save more for retirement if you dramatically lower your living expenses.
What you don’t want to do, though, is incur all the expenses of moving and buying a new home only to discover you hate where you’re living. Do substantial research and visit your targeted communities at different times of year before you commit.
Also, tying up 60% of your portfolio in a single, illiquid asset such as a home is risky. You may well be better off moving to a cheaper area and continuing to rent until you’ve built up a bigger nest egg.
Dear Liz: I am 25 and work part time while I finish my bachelor’s degree. Most of my family thinks the amount I could contribute to a retirement account is too little to bother with opening one, but I would like to get into the habit of having the contributions. I would be contributing only about $25 a paycheck (every two weeks), and this is an optimistic estimate.
I do have about $4,000 in savings right now. Do you think I should go ahead and open an IRA? If so, what should I be looking for in the bank or investment company with which I open the account?
Answer: There’s really no such thing as “too little” when it comes to retirement savings. Everything you set aside can help you on your journey to financial independence.
Furthermore, waiting until you can contribute more is a bad idea, since your expenses will probably rise over time and you’ll always find ways to spend the money if you don’t make saving a habit. Start with those $25 contributions and try to bump up the amount every few months. Once you graduate, look for a job that offers a good workplace retirement plan that will allow you to contribute 10% to 20% of your earnings — preferably with a company match.
For now, though, opening up an IRA or a Roth IRA is a great idea. You may be able to get a tax credit for your contributions if your modified adjusted gross income is below $27,750. (You can learn more about this saver’s credit by reading Publication 590, Individual Retirement Arrangements, or the instructions for Form 8880, Credit for Qualified Retirement Savings Contributions.)
Avoid banks and full-service brokerages, as their hefty fees will eat heavily into your returns. Instead, start with an account at a company that offers low fees, such as discount mutual fund company Vanguard Group or discount online brokerage ShareBuilder.
Vanguard has a $3,000 minimum investment requirement on most accounts and a $100 minimum for additional investments, so you’d need to save up in another account (such as an online savings account) and transfer the money over when you have enough. If you choose its target date retirement funds, though, the minimum is only $1,000 with a $1 minimum for future automatic investments. ShareBuilder allows you to invest without minimums. Automatic investments in certain mutual funds are free, while automatic investments in other funds and stocks cost $4 apiece.