Focus on Lifelong Investing

Why You Need a Roth IRA

One of the smartest money moves a young person can make is to invest in a Roth IRA. Follow the rules and any money you put into one of these retirement-savings accounts grows absolutely tax free: You won't owe Uncle Sam a dime as you let your savings accumulate, or when you cash out in retirement. Plus, an IRA is more flexible than a 401(k) and other retirement plans because you can invest it in almost whatever you want, from stocks and mutual funds to bonds and real estate.

If you haven't yet opened this gift from Uncle Sam, do it now. You have until your tax return deadline to set up and make contributions for the previous tax year. The government sets a limit on how much you can contribute to a Roth. That limit was $5,000 for 2008 and also for 2009. That means if you act before April 15, you can invest $5,000 now to count for last year, giving you a solid start to your savings. And you have until next year's tax deadline to kick in your $5,000 for 2009.

Don’t let the recent market turmoil scare you. Now may be an especially good time to start investing because stocks are cheap -- think of them as on sale. And stocks historically do well over the long-run, so a good place to start is with a well diversified mutual fund. But if you really can’t stomach the market right now, the Roth lets you save in less-volatile investments too, such as bonds or money market accounts. The key is to find your comfort level and get started soon.

The Tax Advantage

The idea of saving on your taxes may seem a tad obscure, but it really can pay off big. If a 25-year-old contributes $5,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have $1.4 million saved by the time she retires at age 65. And the money is all hers -- she won't have to give the IRS a cent of it if she waits until retirement to withdraw the money.

If that same 25-year-old invested that same $5,000 a year in a taxable account earning the same 8% return, she'd only have about $1 million after 40 years if her earnings were taxed at 15% federal. That's more than one-fourth less money than if she'd gone with the Roth. If she owed state taxes on the money, too, she'd be down even more.

Roth Rules

As with any government gift, the Roth IRA comes with a few strings attached. First, you can contribute to a Roth only if you have earned income from a job. Say you're in school, you're not working and you have a little extra money left over from your student loan or your parents gave you money. You cannot put it in a Roth. Also, you cannot save more than you made. So if you worked a summer job and made only $3,000, the most you could contribute to a Roth would be $3,000.

It's also possible to make too much. You can contribute the full $5,000 in 2009 as long as your income falls below $105,000 if you're single, and $166,000 if you're married filing a joint tax return. The contribution limit is then phased out incrementally if you make between $105,000 and $120,000 (single) or $166,000 and $176,000 (married-joint). (SeeIRS Publication 590 for more on calculating your contribution.) Make more than those upper limits, and you don't have to cash out the account -- you simply cannot contribute any more money to a Roth IRA.

If you expect to exceed the Roth income limits at some point during your career, you should open a Roth now while you're young and your salary is low enough to qualify. If a 25-year-old saved $5,000 a year for only five years, then didn't contribute another dime for the next 35 years because his income was too high, that money would continue to grow -- to nearly $481,000 by the time he turned 65. That alone certainly won't be enough to retire on, but it'll be a nice tax-free bonus to his other retirement savings.

Bonus!

If the savings power, flexibility and tax-free status aren't enough to persuade you of the Roth's virtues, Uncle Sam throws in a few extra perks, making the Roth an indispensable tool in a young adult's financial life.

You can take money out in a pinch. Although the purpose of a Roth is to save for retirement, and your money can grow only if you leave it in the account, you can withdraw your contributions at any time, tax free and without penalty -- and you don't have to pay it back, like you do with a 401(k). Of course, it's best to leave your money in the account so you can earn more money, and you really should have a separate emergency savings account on standby, but it's nice to know the Roth is there for you if you need it.

Notice we said you can take out your contributions at any time -- not your earnings. If you withdraw any of your earnings before age 59½, you'll trigger a tax bill on the money, plus you'll have to pay a 10% penalty. Ouch.

You can tap your Roth to buy your first home. The IRS lets you withdraw up to $10,000 from your Roth IRA tax- and penalty-free -- which can include earnings -- to help you achieve the American dream. However, the account must have been opened for five years. That means if you make a contribution now and count it toward 2008, you could use tax-free money from your IRA to buy a house starting in January 2013. That $10,000 limit is per person, so couples could withdraw up to $20,000.

If you don't meet the five-year test, you still can take out your earnings for your home purchase, but you'll have to pay taxes on the amount you withdraw. You won't have to pay the 10% early withdrawal penalty, though.

You can use it to save for Junior's education. Many new parents don't know whether to save for retirement or the baby's college tuition. Hands down, retirement wins. There are loans to pay for college, but none to help fund your retirement. But starting a Roth is a great way to cover both bases, just in case. Focus on your retirement now, saving as much into a Roth as you can. And as your finances allow, consider opening a specific college-savings account for the new baby -- say, a Coverdell or 529 plan. Then, when the day comes for Junior to head off to school, you can assess whether you can afford to -- or need to -- sacrifice some of your retirement dollars to make it happen.

You can, of course, take out your contributions at any time to help pay the bill. If you dip into earnings, you'll owe taxes -- but you don't have to pay the 10% early-withdrawal penalty if you use the money for college. The Roth shouldn't be used as the sole savings vehicle for higher education, but it's nice to know you can use it if you need it.

How to Open a Roth IRA

When you're just starting to invest, the Roth should be your first stop -- even before you open a regular, taxable account, or contribute to a workplace retirement-savings plan. The only exception is if your employer offers a match on your 401(k) contributions. That's free money you don't want to pass up. In that case, contribute enough to win the match, then send any extra money into a Roth IRA. (Yes, you can invest in both a Roth and a workplace retirement plan.)

You can invest your Roth IRA in almost anything -- stocks, bonds, mutual funds, CDs or even real estate. It's easy to open an account. If you want to invest in stocks, go with a discount broker. For mutual funds, go with a fund company. For CDs or money market accounts, you can go through your bank.

Because you're young and have a long way to retirement, you'll want to invest in the stock market to get the highest returns over time. Rookie investors should stick to mutual funds that invest in stocks. They're easy to understand, you leave the stock-picking to the pros, and they make it easy to spread your risk around several stocks or bonds without putting all your eggs in one basket.

Most mutual fund companies even lower their minimum investment requirements when you open an IRA. T. Rowe Price, for example, requires $2,500 to invest in a taxable account, but IRA investors need only $1,000 to get started -- or as little as $50 a month if you sign up with its automatic investing program.

Use Kiplinger's Fund Finder to search for funds that have low investment minimums and that meet your other criteria. Stick to no-load funds with low expense ratios (the average expense ratio for stock funds is about 1.5%).

Many fund companies will let you open an account and make contributions online. Make sure you designate what year the contributions are for.

Not sure where to find the money to fund your account? Consider investing your tax refund. About 70% of us will get a refund this year, and last year the average check totaled more than $2,700. That cash would make a great start to your Roth.

Another way to fund your account is to put it on autopilot. Most banks and brokers will allow you to set up an automatic investment plan taking the money directly out of your bank account and putting it into your Roth. It's much easier to find the cash when it's considered already gone than if you have to make a physical effort to write the check each month.

Focus on Lifelong Investing

Yes, You Can Still Be Rich

How do young people think about money?

As young people, we don't pay attention to our money. When there's something you're neglecting and you just hear bad news, you again don't pay attention, but you feel guilty about it. It's a combination of apathy and guilt that comes with money, just like eating and working out. 'I know I should go to gym four days a week, I shouldn't eat that pizza.' We know that we should be figuring out something about money and should probably do a Roth IRA, but we don't know where to get started. There's so much conflicting advice out there.

Will the recession make 20 and 30-somethings more pessimistic and risk averse for the rest of their lives?

Yes. There's a lot of research to suggest that. It's a particularly bad situation for young people because we're already not investing as much as we need to. Going forward, there will be people who say, 'I'm not investing in the stock market,' or 'Crooks can still my money.' It's hard to convince people, 'No, you have to look long term.' In any 30-year period, the stock market has always gone up.

How can you encourage people to invest when those who were doing so have lost upwards of 50 percent of their money over the last eight months?

There are two separate things: The intellectual and mathematical part, and the emotional part. If I told you nine months ago that you could pick the same investments on a 50 percent sale, it sounds very attractive. But we think of it as a 50 percent loss. Tremendous wealth has been lost, nobody can deny that. But if you're in your 20s or 30s, you don't need money for 30 or 40 years. So on an intellectual and mathematical side, you think, 'I'm going to continue dollar-cost averaging into the market.'

As for the emotional part, I can understand the emotion of saying, 'I've lost so much, I'm going to pull it all out. People often think they have just two levers to pull, put money in or pull money out. But there are other options. You could pull less in, put more in savings, re-allocate investments to put more in fixed income -- there are so many different levers you can pull. If you pull money out, you're guaranteeing you won't be in the market when it returns.

But what if it doesn't return? Japan's stock market has been virtually stagnant for decades.

There are functional and structural differences between us and Japan, but without getting too deeply into that, what strongly effects my belief going forward is what happened in the past. The past doesn't predict the future, but it gives us a fairly accurate view of what's likely to happen. Whether it returns 6 percent or 8 percent -- we can split hairs over that -- the question is, do you fundamentally believe the stock market will go up. If you believe that, then invest. If you don't, where do you put your money? If you only put it in a savings account, it's not going to give you the returns you need to live on. You have to take risks to get potentially high returns.

People like to complain about the economy, but the economy versus your finances are very different. My question is, 'Have you automated your accounts? Do you use a bank account with overdraft fees? Have you set up a conscious spending plan? How much is dedicated to a savings account versus going out and eating?'

I assume you follow your own advice and have money in the stock market, and it must have lost significant value lately. How do you not get down about that?

I built an infrastructure where I only focus on one thing -- earning more. It gets automatically disbursed -- 20 percent to investments, 5 percent to savings, etc. In terms of dealing with losses, first of all, I don't check into my investments every day, and I don't think anyone should. Second, there's a difference between losing when everyone is gaining and losing when everyone has lost.

I'm resolutely focused on the long-term. I do believe the long-term prospects are great, but I'm not a prognosticator. My focus is on living a rich life, which also means being able to visit a friend or buy what you want. Being rich is just partially about money.

Focus on Lifelong Investing

7 Myths About Marriage and Retirement

Think married couples have it easy? Or that you should get your pension policy to pay out as much as possible, as soon as possible? Well, think again. Predicting that you'll die too early--or too late--can leave you and your spouse in a financial crunch. New research upends these 7 common myths about marriage and retirement:

Single people need less money. It's true that that single people spend less money each year than couples, but at all ages over 65, they spend more of their income than couples do, according to research by Michael Hurd, senior economist at Rand. Then, after age 65, single people's income goes down by three percent a year until it dwindles to 20 percent of its starting value at age 95. (For those at age 65, the probability of surviving to age 95 is around 11 percent.) Couples, meanwhile, maintain their income until the oldest member reaches age 79, when wealth starts to decline at around 3 percent a year. (On average, couples start out with three times the wealth of single people.) So while single people may need less money, they also tend to be less prepared for retirement and spend down their savings much more quickly. (Hurd's calculations are based on data from the University of Michigan Health and Retirement Study.)

Married couples have less to worry about. While married couples do tend to enter retirement with greater resources than their single peers, there is a small chance that both members of the couple will survive to old age. According to Hurd, at age 65, the chances that both survive to age 77 is less than half. Once one spouse dies, the surviving spouse tends to spend down their joint wealth much more quickly. By age 95, on average the surviving spouse has just 32 percent of the couple's initial level of wealth.

The worst case scenario is unlikely to happen. A recent survey by AARP Financial found that many people find themselves financially unprepared when the worst case scenario does strike, which compounds the tragedy. The survey, which focused on adults between ages 40 and 79, found that most (57 percent) had already experienced such a crisis, including long-term job loss, divorce, and death of a spouse or partner. Of those who lost a spouse, 63 percent said it had a significant impact on their finances.

Women are especially likely to be widowed, and to run into money problems once they are. According to the Census Bureau, more than 1 in 4 women over age 55 are widows; the proportion rises to two in three for women who are 75 and older. Divorce is another risk factor: While 12 percent of all women over age 65 live in poverty, the rate for divorced women is 21 percent, according to the Government Accountability Office.

Thinking you'll die young--or live forever. Deciding how much to save and spend depends partly on how long you plan to live, a prediction many people get wrong. According to Hurd's research, between ages 65 and 69, people tend to think they'll die sooner than they actually will, which puts them at risk for over-spending. Then, over age 75, people tend to think they'll live longer than they will, which means they may be overly frugal. Women tend to underestimate their chances of living longer compared to men. Between ages 65 to 69, women tend to underestimate their chances of survival by 12 percentage points compared to men's four, Hurd says.

Getting as much money as possible, as early as possible, is best. Many people make the mistake of opting for higher payments from pension or other benefits payments during their lifetimes, which means their surviving spouses are left with less later. Mary McGrath, executive vice president at Cozad Asset Management, a financial planning firm in Champaign, Ill., says even couples with other assets should consider selecting an option that allows benefit payments to the surviving spouse after death, because suddenly losing all income adds unnecessary stress to the grieving process. "It's too upsetting to the survivor to have all of the income cease when you die," she says.

High-earners have less to worry about. While people who earn above-average income during their working lives tend to have acquired more resources than those who earn less, they also need more money in retirement in order to maintain their lifestyle. Hurd adds that another challenge for wealthier individuals is that they pay much heftier taxes, a factor many people forget to take into account.

Retirees should maintain their wealth until age 100. You can't go wrong saving too much, but Hurd says it's reasonable to look at more realistic survival rates. He defines a household as "adequately prepared" for retirement if it has a five percent or less chance of outliving its resources if it reduced its initial spending by 15 percent. By that definition, 83 percent of couples and 70 percent of single people are prepared.

Annuities are too expensive. Hurd says that more people should consider annuities as a way to ensure they maintain their wealth as they age. Annuities, or contracts with insurance companies that allow consumers to purchase a guaranteed income stream, tend to be under-used because people hesitate to pay a large lump sum now for a payout much later. "In my view, individuals are likely distrustful that the annuity will be there in 25 or 30 years when it is needed," says Hurd. But, he adds, "even partial annuitization would reduce the burden of managing the level of spending and the portfolio."

Focus on Lifelong Investing

Tough Choices

It can be hard to make a financial decision when you're faced with two options that each look good. We take five common dilemmas and show you how to choose the most financially sound path.

Some financial decisions are easy. You know, for example, that you should pay your rent instead of blowing the money on an impulse trip to Cancun.

But some financial choices are a tougher call. For example, you know you should build up your savings, and you should pay off your debt. But which one trumps the other? When you're faced with a choice between two worthy options, how do you know which path makes the most financial sense?

We've put together a cheat sheet of answers to five common dilemmas, and we arm you with the tools to help you make the best choices for your situation.

Q. Should I save/invest or pay off debt?

A. Evaluate which option will give you a bigger return on your money.

For example, if you have a balance on a credit card charging 18% interest, paying it off is like receiving an 18% return on your investment. It's pretty hard to find that kind of payoff in the stock market (especially lately). On average, stocks have historically returned about 10% annually.

Of course, despite all the number crunching, there's something to be said for the feeling of being debt-free. If investing makes more sense on paper for your situation, but paying off your obligations will bring you greater peace of mind, go for it. A good financial decision is one that helps you feel in control of your money, not the other way around.

You will, however, want to make sure you have some emergency cash set aside so you won’t have to lean on your credit card when the unexpected happens. It’s a good idea to stash at least $1,000 in a high-yield savings account for that purpose before you start kicking in extra money to pay down debt.

Q. Should I invest in a 401(k) or Roth IRA?

A. Generally, it's best to invest in a 401(k) up to the employer's match -- otherwise you'd be passing up free money. But if your employer doesn't offer a matching contribution, go with a Roth IRA first.

You can invest up to $5,000 in a Roth IRA this year. If you want to save more, you can contribute to your 401(k) after you fully fund your Roth. You contribute after-tax dollars to a Roth, so it won't reduce your taxable income like 401(k) contributions will, but you can withdraw the earnings tax-free once you turn 59½.

This is important if you expect to be in a higher tax bracket when you retire. And there are other benefits with a Roth that you won't get in your 401(k), such as no mandatory withdrawals and no penalties if you need to withdraw your principal early.

But, as we mentioned above, before you invest in any retirement plan, make sure you have your emergency fund underway and your high-interest debt under control.

Q. Should I rent or buy a house?

A. There's no one-size-fits-all answer to this quandary. To come to an answer that fits your situation, ask yourself these four questions:

• Can I afford the monthly payment?
• Do I have enough savings for a sizable down payment? You generally need at least 20% of the purchase price to avoid paying private mortgage insurance. It’ll also increase your odds of getting a loan in the current economy. Low-down financing can help, but you'll still need enough for closing costs, origination fees, and other expenses -- and you'll probably pay a higher interest rate.
• Can I afford the extra costs that come with owning a home, such as insurance, taxes, maintenance, repairs and furniture?
• Do I plan to stay put for at least five to seven years to recoup my initial costs?

Many younger people find that renting is quite a bargain. But that doesn't mean you should resign yourself to a lifetime of renting. Home prices have dropped recently, but that doesn’t matter -- it’s your personal budget that should dictate whether you’re ready to buy. Rather than overextend your finances, you may be better off renting comfortably within your means and save your money for the perfect opportunity when it comes along.

Q. Should I save my emergency cash in a bank account, CD, money-market fund or under my mattress?

A. Nix the mattress. The rule of thumb is to save three to six months' worth of living expenses in case of a financial emergency, such as job loss, unexpected medical bill or car repair. You'll want to put the money someplace safe and accessible, but you don't want it to sit in a standard bank account earning next to nothing. Go with a high-yield online savings account or money market account. These FDIC-insured offerings link to your checking account at your bank, and you simply transfer the money online.

CDs are also safe, and they earn good yields, but they don't satisfy the accessibility requirement. Your money is tied up for the term of the CD, and you'll have to pay a penalty to cash out early. By definition, an emergency is something you do not anticipate, so it's best to keep your money unshackled.

Q. Should I take job A or job B?

A. When choosing a career path, your first instinct may be to go with the one that pays the highest salary. After all, you've got bills to pay. While certainly important, your paycheck isn't everything. To evaluate two viable job offers, you need to look at the entire picture.

Areas you should evaluate include benefits packages, commute times, opportunities for advancement, the work environments, levels of responsibility and job security. And it sounds cliché, but envision where you want to be in ten years. Would one job take you down a different career path than the other?

The same evaluation process works for deciding whether to stay at your current job or try something new. The idea of stepping outside your comfort zone can be daunting, especially if you're leaving your first real job out of college. Breaking the decision down into objective categories helps take some of the emotion out of the process. Take an honest look at the criteria above, and include job satisfaction, stress level and office politics into your equation.

Focus on Lifelong Investing

Five Money Lessons for New College Grads

It's not easy to master money management during the best times and it's especially hard to navigate the challenges of a recession. Still, many of the same basic principles apply in good times and bad. And getting a taste of a downturn at the start may make current graduates smarter and more thoughtful than those who graduate during boom times.

Here are five broad financial lessons that can pay dividends for a lifetime:

This spring's college grads are heading out into a world where jobs are tough to come by. The economic outlook is uncertain and all the older people they know are feeling the pain of stock-market losses.

Worse, there are all kinds of nitty-gritty details to deal with: opening bank accounts, choosing health insurance, finding an apartment, lining up transportation and figuring out how to invest. How is a young person supposed to get ahead in this environment?

1. Savings Matter

Whether you call it rainy-day money, an emergency fund or just reserves, having cash in the bank is important at any time, but it's especially comforting and crucial these days.

In the bigger picture, having savings also means much more than just having money in an account. People who save, for the most part, have learned to live within their means. Most likely, they have a handle on how to budget and how to shop carefully.

The payoff is huge. People with savings have great options. If you aim to have at least six months of living expenses socked away, you can probably weather a job loss or a medical emergency. If you save more, you can take advantage of the downturn in home prices or take vacations and buy cars without getting in a hole.

2. Find the Fine Print

Nearly every transaction these days seems to require a written agreement, from leases to health-club memberships to cellphone services. If you're used to checking "I agree" every time you add software to your computer, you may take other contracts just as lightly. But you'll learn quickly about the costs buried in the fine print once you miss a payment or find yourself on the hook for a $175 termination fee for breaking a cellphone contract.

Wesley Bedrosian

To avoid that headache, look at agreements and contracts as though you were on a scavenger hunt for key facts: How can you end this agreement? How can the other side terminate the deal? What exactly will you be paying and when? And what happens if a payment is late or missed? Knowing the significant details will help you make better decisions and avoid much grief later on.

3. Focus on the Total Cost

Over and over, salesmen will try to lure us into buying a nicer car or house or taking on a longer loan by touting the monthly payment. But if you want to keep more of your hard-earned money for yourself, calculate the full cost including interest and fees before weighing the monthly bill.

For example, some lenders may encourage grads to consolidate and stretch out their students loans, paying them off over 20 years instead of 10 to lower the monthly payment.

Repaying $10,000 in 6.8% loans over 20 years will cut the monthly payment to $76.33 from $115.08. But it will also more than double the interest paid -- and your payments will total about $18,300, instead of $13,800. Understanding the total amount makes painfully apparent just how much money will go to someone else.

4. Debt Is the Great Divide

Taking on some debt can sometimes really pay off, such as when we borrow to buy a home or invest in education. At times, we need to pay off a major purchase or medical bill over a few months. But while debt can be useful, more often than not, debt is a continuing drag on our finances that limits our choices and separates the haves and have-nots.

That's why you need to treat your credit card like a powerful financial tool that has to be managed properly and safely, in the same way that you had to learn the rules of driving a car. If you don't already have a credit card, apply for one before you graduate, since getting a first card can be easier as a student. Limit yourself to one card or no more than two -- one to use regularly and one for true emergencies.

Ask the bank to set a low initial credit limit of, say, $1,000 so that you can't run up big bills. Use email or text message alerts to remind you when the bill is due and alert you if you are near your credit limit. Pay your bill on time and in full every month, or at least pay as much as you can possibly pay. Then, remember this last lesson:

5. There Is a Permanent Record

It's not your academic transcript that will stick with you, but how you manage your money. Credit scores, calculated by credit bureaus based on how much debt you have and how well you manage it, will follow you through your adult life. Over time, that score will affect how much you can borrow, the interest rate you'll pay, whether you can rent the apartment you want and sometimes whether you get a certain job.

Young people won't start out with the highest credit scores because they don't have much of a credit history. But your score will improve if you pay your bills on time, keep your borrowing to 20% or less of your total credit limit and apply for new credit only if you really need it.

A high credit score, just like a growing savings account, means you will have more options. Ultimately, that's what a healthy financial life is all about: having choices to get to wherever you want to go.