No Debt Plan

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Last week I told you how to make sure your money was safe from a bank failure. As I did my research on the topic, I discovered that IRA accounts are also covered at those banks. The FDIC insures your individual retirement accounts up to $250,000.

One of the questions I have received via e-mail in the past revolves around IRA accounts. Namely, if I have a Roth IRA with Bank A, can I open a new one with Bank B? Or are my options unlimited in regards to the number of different individual retirement accounts I can have?

The short answer is yes, you can have as many IRA accounts as you wish. You could open an IRA account up with 100 different banks if you felt the need. Of course you don’t really want to do that. Consolidating into one IRA account with the highest number of quality, low cost investment options would make your life a lot more simple. (Unless the institution it is held at fails.)

You can also have both a Roth IRA and a Traditional IRA. No matter how many IRAs you have you must remember you can only invest the maximum amount across all accounts. Currently that maximum is $5,000 for most people. If you have a Roth IRA and a Traditional IRA you could put $2,500 into each account for a total of $5,000 (rather than $5,000 into each and a $10,000 total).

As I was planning to write this article, Patrick at Cash Money Life put up a great article about the number of different retirement accounts you can have (401k, IRAs, all of them).

What if I have more than $250,000 in my IRA?

As I mentioned at the beginning if you have a Roth IRA with IndyMac Bank and it has $600,000 in it… the FDIC will guarantee the first $250,000. You may be able to get the remaining $350,000 from the bank eventually, but it would be quite disheartening to see more than half of your investment move out of your hands for a while. Disheartening is an understatement. If $350,000 of my money suddenly was inaccessible I would be freaking out.

I can understand in this situation some might consider opening up a second IRA with another institution to hedge your bets against failure.

But remember, bank failures don’t happen every day. And opening up a second IRA with a different institution does not ensure you will enjoy the same low cost investments as with your first IRA. I would recommend finding a quality institution (we use Vanguard) to keep your IRA safe. Plus, I wouldn’t recommend using a bank in the first place as they usually don’t offer the cheapest investments.

I have a guest post that will go live at Consumerism Commentary at 10AM Central that talks about what I see as the benefits of target retirement funds. If you’re visiting from Consumerism Commentary, thanks for stopping by! Please consider subscribing to my RSS  feed and commenting. Your comments are more than welcome.

I thought I’d pair it up with further thoughts this morning about the beauty of automatic rebalancing with a target retirement fund.

We need a foundation of understanding first.

What is rebalancing your portfolio?

Essentially, rebalancing your portfolio is buying/selling certain portions of the portfolio so that the items you are invested in match your investment plan. That doesn’t sound simple, but it is. Let’s say you want to be invested in 90% stocks and 10% bonds. During the year each is going to go up and down, and you might end up one year later with 95% stocks, 5% bonds. Your asset balance is out of whack.

So you sell some of your stock holdings or add more to your bond holdings to get back to your 90% / 10% balance. Every time you do this you are rebalancing your portfolio.

Rebalancing is easy and you probably won’t do it

Many people get busy and forget to even look at their 401k statements or where there investments stand on a year to year basis. Adding in yet another thing you have to do, especially if it involves a little math, makes it more unlikely you will rebalance.

I’ve read elsewhere that many people are invested in ultra-conservative investments in their 401k. Why? Because they don’t know what they’re doing and the “guaranteed return” on a money market fund paying 2% sounds great. If you don’t understand the investments, you probably don’t have an investment plan (which I will talk on in the future). If you don’t have an investment plan, how are you supposed to know what to buy/sell more of to get your portfolio back in balance? It’s a simple concept, but requires a few steps. Result? Most people don’t do it every year.

The Beauty of Target Retirement Funds

One of the most amazing things about Target Retirement funds is they rebalance for you. Automatically. You don’t have to even think “man, what should I buy more of? What should I sell?” The funds automatically adjust for you.

Over time the funds get more conservative. That makes sense. If you are 42 years from retirement (Vanguard Target Retirement 2050) you need more stock holdings in your portfolio. Stocks provide more growth over time than bonds even though there is risk involved. But if you are retiring in two years (Vanguard Target Retirement 2010), you can’t afford an enormous loss in 2009 right before you start drawing income from your retirement account. So as time marches on the funds boost up the bond holding percentage to provide more stable income.

Let’s compare the 2050 fund and the 2010 fund over the last year to prove the point. Remember, the 2010 fund is invested more conservatively with a higher percentage of bonds. The 2050 fund has more exposure to stocks. The blue line is the 2010 fund, the red is 2050. You can click the image for full size.

What do we see? The last year has been a wild ride on the stock market. The fund with the higher allocation of bonds — 2010 — has not experienced as big of a gain or loss over the past year. It comes out to be about 1/2 of what the heavy-stock allocated fund experienced.

That’s to be expected. But just think if you are about to retire, and you are invested in the 2050 fund. You have lost 7-8% over the last year! That can really put a dent into a retirement portfolio. But thanks to the target retirement fund if you have the right date picked out (2010 versus 2050), the funds will automatically get more conservative for you. End result? Hopefully less retirement headache.

I highly recommend starting your Roth or Traditional IRA with a Target Retirement Fund. It is definitely a set it and forget it type investment, which makes things easier for you. I do recommend Vanguard, but I will put up a disclaimer: I am invested in the 2050 fund. That’s it. Vanguard doesn’t pay me to toot their horn. The low fees and exalted status in the investment world is all I need to talk about them.

Chris commented on my post, One Simple Step to Retiring with $1,000,000, with a question about Roth IRA minimums.

You say the max is $5,000 is there a minimum? If I can’t afford to do the $416.67 per month, what is the lowest that I can go without any kind of penalty. Or can you go without putting anything in for a year or two, not that you would want to do that. Just curious, I’m not completely familiar with the way the Roth works. Thanks Kevin!

The best answer? It depends.

There could be a few different minimums: minimum to invest in a mutual fund, minimum amount required to open the account with the firm, or minimum amount you can add additional funds to your account with.

There are a multitude of places you can setup your IRA/Roth IRA. A bank, brokerage firm, or directly investing with a mutual fund/investment firm are a few options that come to mind. Each is going to have different requirements of you to open up an account.

For example, we use Vanguard for our Roth IRAs. To invest in Vanguard’s mutual funds — through Vanguard or a brokerage firm — you need $3,000 as a minimum to invest in that mutual fund. The only exception is the Vanguard STAR fund with a minimum of $1,000. Everything else you need $3,000 to get started. However, after that the smallest amount of money you can then add to that fund is $100 if I remember correctly. You don’t have to save up $3,000 at a time unless you want to use multiple funds. We are currently invested in a Target Retirement Fund to get started, so we have no need for another fund right now.

If you setup an account with a bank or brokerage firm you would have an array of options to invest in. Some would have higher minimums than others. Some of the firms may even require you to have a certain amount just to open the account regardless of how much you invest in each mutual fund or stock.

It really does all depend. We have been completely satisfied with Vanguard in the short time we’ve been with them. We didn’t have $3,000 saved up initially, but just set aside money each month until we reached the minimum.

My advice? Just get started today. Do whatever it takes. Set the money aside in an online saving account like ING until you have enough to start investing. Step by step you will get there. Just remember the first step is always the hardest.

Update #2: I also answered a question from the comments below in a different post. It addresses Roth IRA minimums.

Update: Hello StumbleUpon users! Learn more about me or read some more articles. Thanks for all of the up votes! Please leave comments on your thoughts. We had a bit of discussion over at Stumble Upon with some of the reviews, so check those out, too.

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I’ve got a keen interest in learning more about how changing one thing in your life can have a huge impact further down the line. More on that in the future.

The Roth IRA is one of those changes. One simple decision that can truly change your life.

The government allows you as an individual to set aside $5,000 (as of 2008) per year of after-tax money for your retirement. I decided to use the Roth for this example because it eliminates taxing gains on your investment, which makes the example a lot more simple.

So what happens if you start early and set aside just $5,000 per year?

Let’s run the numbers.

Using Excel, you can calculate what amount of money you would end up with based on the following criteria. I’m using myself as an example because, well, I know everything about me.

• Age: 24
• Retirement: 66 (I would rather retire earlier than this, but am willing to work this long)
• Annual Contribution: $5,000 after-tax dollars
• Annual rate of return: This can vary greatly. We’ll stick with a very conservative 7% per year.

You can make changes and run your own calculations with my Roth IRA calculator (in Excel).

Long story short? If you start early, you can retire as a millionaire by just using one investment vehicle. No need for five different accounts with three different brokers. A simple Roth that through whatever investments you chose earns 7% per year, nets you $1.2 million (give or take some due to rounding error). You can see a chart of your cumulative contributions compared to the balance in the account. See how much you are earning at the end without having to put more money in — the beauty of compound interest. (You can click on the chart to see the full size.)

For those who like easy steps:

• Pay off debt, live a debt free life.
• Commit to putting away $5,000 after-tax money into a Roth IRA. That’s $416.67 per month.
• Invest in index funds like Vanguard’s Total Stock Market, Total International Stock Market, and Total Bond Market. Lower fees = higher returns.
• Earn a ‘measly’ 7% return on your investments each year until retirement.
• Retire with $1.2 million.

Want to run your own numbers? I’ve uploaded the handy Excel workbook for you.

Yesterday I Googled “retirement calculator” so I could run some numbers. I wanted to pick an amount that we could contribute to our Roth IRAs each year — say, $3,000 each — and discover where we would stand in retirement. As you might expect, there were plenty of calculators to be had. The one I enjoyed using the most came from CNN Money.

I liked this calculator the most primarily because:

• it asks for a lot of data
• it shows you where your portfolio would stand at differing options (10% chance of knocking the ball out of the park with incredible returns, 25% of nice returns, 50% of this actually happening, etc.)

We have little saved for retirement — and that’s okay. With roughly $1,400 in a 401k (3% contribution), $3040 in a Roth IRA, and my wife’s retirement account with the state (5% contributed), we’re just getting started at ages 23 and 22. I put our ages in at 24 and 23 in the calculator because it was taking it off of what age we would turn this year. (Our birthday’s are in April and May.)

When input our data and add $6,000 in total Roth IRA contributions per year, we get some very favorable results. The end result is we should be able to have 70% of our pre-retirement income if our investments net a return of only 3.3%. This is extremely encouraging.

Do It In Excel (or Other Spreadsheet Software)

There is a way to do some of these calculations in Excel that I want to show you. You can calculate the future value of present dollars, plus any additional payments. It won’t account for inflation, at least not easily. Open up Excel (or OpenOffice Spreadsheet) and click on a cell. Type everything but the quotes at the beginning and end: “=FV(8%,42,-3000,0,0)”. What you are telling Excel you want to know is what is the future value (FV) of a constant return (8%) for the next 42 years (66-24=42) with constant payments of $3,000. The 0’s at the end are saying there is essentially no money in the account yet. And yes, you do put -3,000 in the formula or you end up with a negative number.

What do you come up with? $912,730.57. Not too shabby for only $3,000 per year.

There is a second way to estimate the future value in Excel. Essentially you calculate the gain for each individual year and run the calculation until X year of retirement. You can download the Excel file I did the work in, too. (It also shows the future value formula at the bottom.)

For the second method, you are going to calculate the beginning balance, contribution (payment), return, and ending balance for every year. Once you do it for the first two years, you can drag the results down to auto-complete for the next 20, 30, or 40 years.

This results in a slightly different end number that the future value formula: $1,067,848. I’m not sure why there is a difference, so maybe someone who reads this can explain. However, they are pretty close.

The Catch:

• This will show you what the future value of today’s dollars would be. It does not account for inflation. Essentially you are assuming that you will contribute the equivalent of $3,000 of today’s dollars for all of the years. So fifteen or twenty years from now, $3,000 of today’s dollars could be $4,800 or $5,500.
• This assumes a constant rate of return: 8%. Some years you may earn 15%, others you may lose 20%. It could average out to 8%, but that would affect the calculations. This is where the CNN Money calculator can help.
• The younger you are when you start, the better. If I waited 10 years until I was 34, then the end result is only worth $472,880. A difference of almost $600,000. So get out of debt, and get started.
• Waiting longer to retire is also extremely beneficial. If you look at the Excel file I put up, the last year the investment gain is $79,000! If I wait one more year, I’ll earn another $85,000+. There is some serious money at the end.

I hope this helps dissect some of the numbers for you. Additionally, now you know there are at least three different ways to guesstimate at your retirement nest egg (and you can do two yourself).

That pretty much says it all. Last night I went to Vanguard’s website and signed up for our first Roth IRA (in my name). We had originally planned to open my account with Vanguard’s Total Stock Market Index (VTSMX), and the next contribution (whether to my account, or to open up one for my wife) would be Vanguard’s Total International Stock Market (VGTSX). We would continue to contribute to both funds for diversification.

However, it is going to be a while before we have another $3,000 saved up to invest in another Vanguard fund. That means it would be a while before we can better diversify.

So last night I made the choice to give us instant diversification with Vanguard Target Retirement 2050 (VFIFX). Target Retirement Funds are really “funds of funds”. This means the mutual fund doesn’t invest in individual stocks. Instead, it invests in other Vanguard mutual funds in this breakdown:

• 71.61% - Vanguard Total Stock Market Index
• 10.26% - Vanguard European Stock Index
• 9.89% - Vanguard Total Bond Market Index
• 4.66% - Vanguard Pacific Stock Index
• 3.34% - Vanguard Emerging Markets Index
• 0.23% - Vanguard Total Stock Market ETF

I think the bond allocation is way too high, in fact I would prefer it to be 0%. I looked at some of other Target funds and they all had very similar asset allocations. I’m willing to give up the 10% for bonds if I can get instant diversification. In the future, we may add more to the stock funds (buying them individually) to up our percentages.

Nonetheless, we’re started. And that’s worth something — first step counts!

This has been quite the busy week in our house. This past weekend I went on a road trip to Memphis with 4 of my best friends from college. Rendezvous ribs, Graceland, and a few nice pubs. And to top it off, I didn’t go into debt to do it. I had enough spending money set aside to pay for the whole gig. I also had a test in my MBA class last night, so the rest of the week was spent studying. Work has been hectic, and not allowed for a lot of writing.

So I have a question for anyone out there. I’ve posted it on the Get Rich Slowly forums, too.

The question:

We are planning on setting up our Roth IRA either this month or next. We should have the $3,000 required for investment with Vanguard. We are setting up the IRA for 2007, so we can maximize what we can contribute this year (2008).

Can I file my taxes, or should I fund the Roth IRA first before filing? That is, does filing my taxes officially close my ability to fund the Roth for 2007?

Any help would be greatly appreciated! Have a great Friday.