Save or pay debt? Do both

Dear Liz: I am a 67-year-old college instructor who plans to teach full time for at least eight more years. Last year I began collecting spousal benefits based on my ex-husband’s Social Security earnings record. Those benefits give me an extra $1,250 each month above my regular income. I have been using the money to pay down a home equity line of credit that I have on my condo. The credit line now has a balance of $29,000. I have about $200,000 in mutual funds and should have a small pension when I retire. (I went into teaching only a few years ago.) Would it be better for me to split the extra monthly $1,250 into investments as well as paying off my line of credit? The idea of having no loan on my condo appeals to me, but I wonder if I should try to invest in stocks and bonds instead.

Answer: Paying down debt is important, but opportunities to save in tax-advantaged retirement plans are typically more important. Fortunately, you probably have enough money to do both.

First investigate whether your college offers a 403(b) or other retirement program that offers a match. If it does, you should be contributing at least enough to that plan to get the full match.

Your next step is to explore an IRA. Since you’re covered by at least one retirement plan at work (your pension), you would be able to deduct a full IRA contribution only if your modified adjusted gross income as a single taxpayer is $59,000 or less in 2013. The ability to deduct a contribution phases out completely at $69,000.

If you can’t deduct your contribution, consider putting the money into a Roth IRA instead. Roth contributions aren’t deductible, but withdrawals in retirement are tax free. Having a bucket of tax-free money to draw upon in retirement can help you better manage your tax bill, which is why some investors opt to contribute to Roths even when they could get a deduction elsewhere.

People 50 and older can contribute up to $6,500 this year directly to a Roth if their income is under certain limits. (For singles, the limit for a full contribution is a modified adjusted gross income of $112,000 or less.) If your income is over the limit, you can contribute to a traditional IRA and then immediately convert the money into a Roth IRA, since there’s no income limit on conversions. (This is known as a “back door” Roth contribution.)

Since you’re so close to retirement, you don’t want to overdose on stocks, but you still need a significant amount of stock market exposure so that your money has a chance to offset future inflation. You might consider a balanced fund that invests 60% in stocks, 40% in bonds.

Once you’ve taken advantage of your retirement savings options, you can direct the rest of your Social Security benefit to paying off your home equity line. These credit lines typically have low but variable rates. Higher interest rates are likely in our future, so paying this line down over time is a prudent move.

Why delaying Social Security can make sense

Dear Liz: Your comments about the benefits of delaying Social Security misled readers. While a cost-of-living increase was standard for many years, it no longer is. You might want to check back over the last 10 years to get details. In addition, a reader might interpret your points about the increased benefit at full retirement age versus the benefit amount at 62 as a promise for the future. Factors such as health and family longevity are also involved. Depending solely on one’s Social Security check for living expenses will most likely bring derisive laughs for those who unfortunately have to do just that.

Answer: Your comments are a good example of why it’s important to get a second opinion on Social Security benefits, because what we think we know about the program may not be true.

One of the best reasons for delaying Social Security is to claim a bigger benefit down the road, a benefit that has nothing to do with cost-of-living increases. “Retirement benefits increase by 6 2/3% each full year an individual waits between age 62 and 65,” said Patricia Raymond, regional communications director for the Social Security Administration. “For each additional year an individual delays benefits from age 65 until full retirement age, the benefit increases 5%.”

The full retirement age is now 66 and will increase to 67. Even if Social Security is restructured sometime in the future, it’s highly unlikely that the system would stop rewarding people for delaying retirement or that cost-of-living increases would be discontinued (although they may be reduced).

By the way, there have been only two years in the last 10 when there was no cost-of-living increase, as you can see at http://www.ssa.gov/cola/automatic-cola.htm. Increases have ranged from 1.7% this year to 5.8% in 2009. The average for the last decade was 2.56%. Whether these increases truly keep up with inflation is questionable, especially with increasing Medicare costs, but to say cost-of-living adjustments are no longer “standard” simply isn’t true.

Trying to decide when to take Social Security based on your current health or your family history of longevity is tricky, at best. Taking Social Security early might turn out to be a good decision if you die relatively early, or it could be a big mistake if you live longer than expected or you have a surviving spouse who may depend on your benefit. (Starting your retirement early would reduce not only your check but also the check a survivor would receive.)

The AARP website has a Social Security calculator that can help you understand the ramifications.

Obviously, some people have little choice but to apply for Social Security as soon as they’re eligible because they need the money. But delaying Social Security for a bigger benefit can be seen as a kind of longevity insurance for those who can afford to do so. Even people in poor health or who lack a family history of longevity might want to hedge against the possibility of outliving other assets, either for themselves or their spouses.

Ideally, no one would rely solely on Social Security benefits, but unfortunately many do. Social Security constitutes 90% or more of income for nearly half of single retirees and more than 1 in 5 married couples. For most people who receive Social Security, the checks represent half or more of their income. So it makes sense to learn how to maximize your benefits using information from reliable sources. In addition to the Social Security and AARP websites, you can learn more from the excellent primer “Social Security for Dummies” by Jonathan Peterson.

Playing it safe could mean losing money

Dear Liz: The certificate of deposit I owned in my Roth IRA recently matured. I’ve put the money into a Roth passbook account until I can figure out what to do with it. I’m a public school teacher and have a 457 deferred compensation plan to which I contribute monthly. I am 57 and will need to work until I am at least 65. What should I do with the money in my Roth?

Answer: As a public school teacher, you probably have a defined benefit pension that will give you a guaranteed monthly check for life once you retire. Depending on how long you’ve taught and where, this pension could cover a substantial portion of your living expenses.

The guaranteed nature of this pension means that you may be able to take more risk with your other investments. That would mean your Roth could be invested in stock mutual funds or exchange-traded funds that offer potential for growth. CDs and other “safe” investments can’t offer that — in fact, your money loses purchasing power since you’re not earning enough interest to even offset inflation.

Since you’re so close to retirement, you should invest a few hundred dollars in a session with a fee-only financial planner who can review your situation and offer personalized advice.

Use windfall to boost retirement savings

Dear Liz: What would you suggest that someone do with $20,000 if the someone is closer to 40 than 30, single, with $100,000 of student loan debt and a $250,000 mortgage? My salary is around $100,000 a year. I have an emergency fund equal to six months of expenses and I make an annual IRA contribution since my employer doesn’t offer a 401(k) plan. Should I accelerate my student loan payments, since the interest isn’t tax deductible for me because my income is too high? Or should I invest instead? If I invest, should I put it all in a total market stock index fund or is that too risky?

Answer: Even if you’re making the maximum annual IRA contribution of $5,500 (people 50 and older can contribute an additional $1,000), you’re probably not saving enough for retirement. You can check the numbers using a retirement calculator (AARP offers a good one at its website, http://www.aarp.org). If indeed you’re coming up short, then consider opening a taxable brokerage account and earmarking it for retirement. You can use a chunk of your $20,000 windfall to get started, but also set up regular ongoing contributions.

The bulk of your retirement money should be invested in stocks, since that’s the only asset class that consistently outperforms inflation over time. If you try to play it too safe and avoid stocks, your purchasing power is likely to decline over the years instead of growing. A total market index fund with low expenses is a good bet for delivering diversification at low cost. But leaven your portfolio with bonds and cash as well, since these assets can cushion market downturns. All the returns that stocks give you in good markets won’t be much help if you panic and sell in a bad market. People who try to time the market that way often miss the subsequent rally, so they wind up selling low and buying high — not a winning way to invest.

If you don’t want to try to figure out an asset allocation, look for a low-cost target date fund. If you plan to retire in about 25 years, you’d want to look for a “Retirement 2040” fund.

Once you get your retirement savings on track, then you can start paying down that student loan debt. Target private loans first, if you have any, since they’re less flexible and have fewer consumer protections than federal student loan debt.

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What to do with extra cash when an auto loan is paid off

Dear Liz: I’ll be done paying off my car in a couple of months. What’s a good strategy for redirecting that money once it’s paid off? Should I use the whole amount each month to start saving for my next car, or would I be better off splitting it up and putting it into several savings “buckets” such as retirement, emergency and my next car? I’m 35, have an emergency fund equal to four months’ living expenses and only one other debt, a very low-interest student loan.

Answer: If you aren’t already contributing to a retirement plan, you should be. If you aren’t contributing enough, that should be your priority even before you pay off your debt.

Market researcher and Yale University professor Roger Ibbotson has found that people who start saving for retirement after age 35 have an extremely difficult time “catching up.” They’ve lost a crucial decade or more, and often can’t set aside enough to offset their late start.

If you are on track for retirement and are comfortable with your emergency fund, saving to pay cash for your next car is a reasonable course.

Insurance better than 401(k)?

Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.

Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.

Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.

Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.

The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”

Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.

The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.

In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.

Can’t afford to save for retirement?

Dear Liz: Is it reasonable for a 50-year-old single man helping with support of a teenage child and earning a steady $35,000 a year to save for his retirement? Rent alone takes $800 a month; food, car and health costs leave little discretionary money.

Answer: Can you reasonably expect to live on Social Security alone? If making ends meet now is a strain, imagine trying to get by on about $1,230 a month (which was the average Social Security check in 2012). Your check could be higher or lower; you can get an estimate at http://www.ssa.gov/estimator.

If you can’t scrape by with whatever Social Security offers, then you need to find a way to save. You should be able to increase your savings once your child support ends, but you should get started now.