Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Archive for October, 2008

Luxury

Creative Commons License photo figure credit: jonworth

The central tenet of personal finance is to spend less than you earn.  A close corollary to this is to learn to live with what you have.  If you can learn to be happy as things are, then it makes it easier and easier to save more and more as time goes by.  I wrote about these ideas in one of my first posts at this blog.

Last week, I found out that I am getting a raise to go along with a promotion that I got a couple of months ago.  The challenge with getting a raise is to keep the central tenet and the corollary in mind: don’t increase your standard of living, and put most of the raise to work for your future.  To do otherwise is what is commonly referred to as “lifestyle inflation.”

Lifestyle Inflation occurs when people continue to increase their standards of living as their means increase.  There is generally nothing wrong with enjoying a higher standard of living — if you can afford to.  Many people are already right on the edge, living paycheck to paycheck, and one unplanned expense away from financial disaster.  However, when these same people get a raise, they raise their standard of living so that they are now spending all of their new income, but are still continually on the edge of ruin.

There are two ways out of this cycle: spend less or earn more.  Most of us have a great deal of control over the former, and at least the perception of very little control over the latter.  In order to break out of the paycheck to paycheck paradigm we have to trim our budgets so that we have some money to save each paycheck, not succumb to lifestyle inflation, or do at least some combination of both.  (Of course, another easy way to avoid lifestyle inflation is to have your spouse get laid off in the same week that you receive your raise!)

Many people, especially in this economy, are lucky to be getting any raises at all, and those that are may still not be keeping up with inflation.  However, it still makes sense to me to try to forget about the raise when you get it and focus instead of how that extra money can be used to advance your financial plan: paying down debt, additional retirement savings, down payment fund, new car fund, emergency fund, college savings for the kids, increased charitable contributions, etc.

Another great strategy, if you can’t stomach the idea of never getting a raise is to split raises with yourself. While it may sound crazy, splitting raises with yourself will still allow you to enjoy some of the benefits of your newfound wealth, but also advance your overall financial plan.

Realizing that “stuff” doesn’t make you happy can be very empowering.  If you can forgo lifestyle inflation for an extended period of time, you can quickly get to a point where you are saving a substantial amount of your income.  I recently read a story about a couple who saved raises for 10 years (looking for a link, anyone have one?)  Imagine for a minute how early you could retire if you were saving 30% or more of your income.  Avoiding lifestyle inflation also offers more security: if you only need a fraction of your income for your base needs, layoffs and other economic crises will be far easier to weather.

Ultimately though, none of this matters if you don’t have a spending plan, don’t pay yourself first, and don’t track your spending.

Are you guilty of lifestyle inflation?  What do you do when you get a raise?  Let’s hear what you have to say in the Comments Section below!

If you liked this article, you may be interested in seeing some related articles:


10.22.2008
Sunset

Creative Commons License photo figure credit: notsogoodphotography

Well I suppose I thought our jobs were untouchable despite the bad economy. In retrospect this is exactly why it is important to closely monitor your finances and have an emergency fund available in tough times. I found out this week that my boss is really struggling to find work for me and in the last few weeks, for himself as well. The work has been great for almost 2 years and it has given me the opportunity to see my little girl grow and change every day, as a stay at home, work at home mom.

But now I am faced with a decision. My boss met with me last week and shared the bad news. He gave me three options:

  • I can continue to be on his payroll without the current guarantee of 20 hrs/wk. This could mean that although he may be able to give me up to 20 hrs, in the current economy 0/wk may be more likely for the foreseeable future.
  • I can become a contract employee. If he has work and I need/want to work, I can. If not, there are no worries or obligations for either of us. This will also mean a higher hourly rate due to the fact that he won’t have to pay payroll taxes. It also means that I can look elsewhere for other contract work.
  • The third option is to be laid off and collect unemployment benefits.

So I took a look at how the unemployment benefits would break down for me. I’m in a unique situation in that I make a good hourly rate, despite only working 20 hrs/wk, but still wasn’t sure what that would mean for me since I only work part time. As MITBeta has said in the past, we can meet all our financial obligations on his income, but without some contribution from me, it is difficult to save and pay down debt aggressively.

Here is what I came up with in regards to our State’s unemployment insurance benefits.  I am assuming I made $40/hr for the last quarter and $35/hr in the previous three quarters.  You basically earn up to 50% of your weekly rate up to the maximum benefit of $628/wk. They take your highest two quarters over the last year to figure out the weekly rate. Using my hourly rate of both $35/hr (this was while I was receiving health benefits) and $40/hr (after we switched to MITBeta’s health plan), I came up with about $750/wk. You are eligible for 30 times that amount as your benefit credit or about $11,250 in my case. Assuming 50% of that weekly rate to be $375/wk that comes out to 30 weeks of benefits.

I think I am also eligible for an additional $25 for our daughter. So the total benefit would be around $400/wk or around $340 if we had state and federal taxes taken out.

They allow you to work up to a 1/3 of your benefit rate. So for me that would be around $125/wk. I am in the process of talking with my former employer about working for them as a contract employee. They may or may not be able to give me anywhere from 5-20 hrs/wk. If I could get an hourly rate of $40/hr from them I would only be able to work 2-3 hrs before I became ineligible for benefits. You can get partial benefits, but obviously at this point we’d need to weigh the cost of my time to keep up with the job search requirements of unemployment insurance.  Given the fact that I am 7 months pregnant I am not really looking for a full time commitment, but just a chance to try working for another company from home to see how it would work. If it works well it would allow me some flexibility after the baby is born and give me more options in a downturn economy. Although both companies are in construction, the sectors they service are vastly different and are affected by the economy in different ways.

What do you think? Have you been laid off and have you filed for unemployment benefits? Are you an employer that has had to lay off an employee? Let us know about your experience in the Comments Section.

401k tip jar

Creative Commons License photo figure credit: _e.t

A reader writes:

“Due to current economic trends I have suffered a rather costly loss and one of my 401K’s dropped below the minimum of what they need to be to stay open.  I got a letter in the mail with options of what I can do with it. I was wondering what you would do in this situation?”

While the loss of value in your 401k is unfortunate, this situation forces you into a beneficial situation.  Generally 401k plans have fewer investment options and sometimes more restrictions on how frequently you can move into and out of those options.  Moving your retirement money to an Individual Retirement Account (IRA) opens up a lot of investment options.

The major question is what type of IRA to use: Traditional or Roth.  A Traditional IRA is very much like a 401k in that money is put into it pre-tax.  Money and earnings in a TIRA grow untaxed as well, and only withdrawals are eventually taxed.  A Roth IRA uses post-tax money.  Earnings and withdrawals from a Roth are non-taxable, and you can also withdraw principal (but not earnings) from a Roth IRA at any time without penalty (though this practice is not recommended by this blogger).

The question of choosing one type of IRA over the other can be very complicated, but the general rule of thumb is to consider whether or not you have yet reached your full earning potential, and therefore whether you are yet at your highest tax burden.  If the answer is “yes”, then a TIRA is probably your best bet, since you will likely have a lower tax burden in retirement, and therefore you want your earnings taxed then.  If the answer is “no”, then a Roth is probably a good choice because your retirement earnings will likely be higher than they are now, so you want your contributions taxed now.

With all that said, I think there are a few questions that you have to ask yourself to make the best choice:

1. How much money is in the 401k that you are about to roll over? My presumption is that it’s not that much, otherwise the plan custodian would not be closing your account.  In the grand scheme of things, this probably means that it will not make that much difference one way or another which option you choose.  However, the amount you have to invest may have some effect on what fund options are available to you in the particular option you choose.

2. Are you currently contributing to an IRA and/or do you plan to contribute to one soon? Related to Question 1 above is the issue of how much money you have to invest.  The fund option availability issue can be mitigated very quickly if you’re already contributing to an IRA or plan to do so soon.

3. How much money do you make? Your income determines your eligibility for TIRA and Roth IRA contributions, which relates directly to Question 2 above.  If you’re covered by a 401k plan at your current employer, then your Adjusted Gross Income (AGI — income after tax exempt deductions such as 401k contributions and Health Savings Accounts) has to be less than $53,000 if filing singly or $85,000 if filing jointly (there’s another pesky marriage penalty…) to be eligible to contribute to a Traditional IRA.  The AGI limits are $99,000 for single filers and $156,000 for joint filers for Roth IRA contributions.  Both types of IRAs allow up to $5,000 per person in contributions in 2008.  There are a number of little nuances to these rules, so you should check the link at the top of this paragraph to see the relevant tables pertaining to your particular situation.

With all that said, here is how I see your options:

1. Roll your 401k straight to a Traditional IRA.  This is the most common and straightforward move you can make.  The biggest problem that you could run into is not being able to meet the minimum amount required to buy into a particular mutual fund.  I’ll talk more about this in my next post on this subject.

2. Roll your 401k to a TIRA and then recharacterize it to a Roth IRA.  This may be a good option if your AGI is less than $100,000.  The downside to this option is that you will have to pay taxes on the money you have invested as if it were income, and you will have to file some additional paperwork with your tax return next spring.  Since it’s not a lot of money, the taxes won’t be that great.  You can pay the taxes out of the principal or out of pocket.  The latter option is preferred so that you keep the greatest amount of money working for you, but means you may have to come up with the cash in April if you’re expecting a refund but it doesn’t cover the taxes owed on the conversion.  Example: If you have $3,000 in the plan and you’re in the 25% tax bracket, then you’ll owe $750 in taxes.  You can reduce your principal balance to $2,250 to cover this, or you can come up with $750 on your own.  The bonus to the 2nd option is that you get to keep that extra $750 in the plan and growing tax free for the next 30-40 years.

3. You can take a distribution on the money.  This is probably the worst option (I like nuance, otherwise I would have said, “This is, by far, the absolute worst thing you can possibly do with this money.)  If, for example, you happen to have a credit card that is currently charging an exorbitant interest rate, like in the 30% range, then it may be in your best interest to use this money to help get out of that pickle before refocusing on retirement.  The downside to this option is that not only will you have to pay taxes as in Option 2, but you will also face a 10% penalty on the early withdrawal of 401k funds if you are under 59 1/2.  So that $3,000 turns into $1,950 just like that (imagine fingers snapping).  Just to be clear: Option 3 is nearly always a bad idea.

In my next post on this topic I will cover how to pick a new custodian for this money, how to set up an IRA, how to move the money from the 401k to the IRA without incurring expenses or taxes, and some thoughts on good fund options to get you started.

What would you do if you found yourself in this reader’s shoes?  Do you prefer to use Traditional or Roth IRAs for your non-401k retirement investing?  Let’s hear your thoughts in the Comment Section!

10.14.2008
Overhang

Creative Commons License photo figure credit: Akuppa

With the recent market turmoil, there has been a lot of talk in the press and even around the water cooler about the nature of risk.  Most people seem to understand that investing in the stock market is risky.  They also understand that the more risk one takes, the greater the possible upside and downside of the investment.  What many don’t seem to understand is what, exactly, is risky about investing in the stock market as well as how risks can be mitigated.

A great book on this subject is A Random Walk Down Wall Street by Burton G. Malkiel.  This book details, for example, why a well diversified stock portfolio is less risky than a single stock.  Malkiel shows that it takes a minimum of 20 to 30 stocks across a number of asset classes to provide sufficient diversification for a typical investor.  For example, if one holds the 30 companies in the Dow Jones Industrial Average, a typical market cycle might have Coca-Cola announce a new product offering which boosts its stock price, while 3M announces layoffs.  These types of stock movements are offsetting and are generally the reason why a diversified portfolio is less risky than individual stocks.

A diversified portfolio is still exposed to “systemic” effects on the market — effects that are spread across the whole market.  This is most easily observed in the current market turmoil.  Clearly it’s not possible for every company to be doing poorly right now — somebody must be making money in a Bear market.  But the market average is down, and as a result, many good companies are getting hit hard on their stock prices simply because of the financial crisis.

Another aspect to risk, and the one about which I have been trying to remind my coworkers and friends, is the time factor.  When purchasing an investment, one has to be aware of both the time one can afford to tie up money in the investment, as well as the typical time for the investment to achieve the kind of return being sought.  This is fairly easy to see with a Certificate of Deposit: you buy a CD that pays a certain percentage yield and that has a limited lifetime of months or years.  There are penalties for withdrawing money early.  The equation is less well defined when it comes to investments such as houses, stocks, or tulips.  The risk with investments such as these (well, not the tulips as much…) is not that the investment won’t hold value or yield a return, but rather over what time period the investment will pay off.

Conventional wisdom suggests investors be prepared for minimum investment times to substantially reduce the chance that the investment will depreciate while held.  The purchaser of a house, for example, should be prepared to hold the house for 5 years or longer to have a high degree of certainty that the money invested can be recovered in full.  Diversified stock portfolios are more like 10 years of holding time.  In fact, (according to Malkiel) there has never been a 10 year period since 1926 in which the stock market has returned a negative yield, and there has never been a 25 year period in which the return was less than 8%.

The point in all of this is that you should not panic about the volatility of the current market.  In fact, the less you pay attention to it the better off I expect that you’ll be.  If you are investing for retirement and you have ten years or more left to invest, you shouldn’t even sweat during this crisis.  If you have less than 20 years until retirement, or are retired already, you should have made and be making annual or semi-annual changes to your portfolio to reduce your risk exposure by locking up your stock gains in less risky vehicles like bonds.  This is what’s known as rebalancing your portfolio.  If your time horizon for a certain pile of money is shorter than 10 years, then your exposure to the stock market should be minimal.

The absolute worst thing that you can do right about now is to get scared and change the way you are investing because of the market fluctuations.  Selling off stock now is the opposite of what everyone knows is the key to investment success: buy low, sell high.  Selling now is “selling low” and locks in your losses.  I have not lost any money in the current market, and I say this because all my losses are on paper so far.  I still own the same number of shares this week as I did last week.  Only by selling shares now can I be sure to lose money in this market.  History tells us that some of the greatest days in the stock market follow some of the worst, and Monday’s stock market performance is certainly evidence of this.  Selling when the market is low takes your money out of play and eliminates any chance of regaining the value lost in your portfolio as the market rebounds.

Are you concerned about the loss of value in your 401k plan?  Have you made any changes to stem your losses, or are you just gritting your teeth and bearing it?  Do you find yourself checking the value more frequently or less frequently because of the volatility?  How much risk can you stomach? I’d like to read your perspective on the situation in the Comments Section below.

ticker

Creative Commons License photo figure credit: zesmerelda

On Monday of this week, I had to leave the office early to visit the home of one of my company’s customers.  On the car ride, I listened to story after story on National Public Radio about the Financial Crisis, and more specifically the fact that despite the passage of the rescue bill over the weekend, stocks were falling through the floor.  The Dow Jones Industrial Average was set to close below 10,000 points for the first time in years.  And all the time I couldn’t think of anything else but to call ScrapperMom, who would likely be near a computer, and ask her to move some of our cash into equities.

Thank goodness I didn’t, because the market has lost almost 15% since then.  But now I’m just salivating more at the prospect of picking up some market index funds at such low prices.  Am I crazy?  I’m not sure.  Everyone is reacting to the market — and all in different ways.  But the truth of the matter is that the rational me knows that I probably should not change my long term investment plan based on what the market did today.  So it really requires me to take another look at my investment plan and then act accordingly.

Here’s where the problem comes in: I don’t really know what my long term investing plan is.  We’ve written here before about many of our financial goals and priorities. Since visiting a financial planner for a free consultation about a month and a half ago (Side story: The planner at the time had hinted at the suggestion of bonds issued by Lehman Brothers since they were paying something like 7% interest… I wonder why I haven’t heard from the planner since our meeting…), we finally decided to reduce the aggressive paydown of our low interest debt in favor of other priorities.

Saving for retirement is certainly one of those priorities, and given this, the current market is the perfect time to invest in order to capitalize on the “buy low” strategy.  Sure, the market could go lower still, but the rebound, whenever it does occur, will almost certainly end up higher than the current market within 20 to 30 years, and therefore money put into the market now should be a good investment.

However, building a substantial emergency fund is also one of our priorities, and given the current state of the economy, cash is probably not the worst position for our money.  While both of our jobs seem fairly secure over the next year or so, the truth is that anything could happen at any time.  I actually have no idea whether my paycheck is dependent on the ability of our parent company to borrow money, and if so, what will happen if it becomes unable to do so.  ScrapperMom works in a field that caters to higher-end tastes, and so far the only effect the slumping economy has had on her line of work is the choice of whether to build the garage to the vacation home now, or hold off until the market rebounds a bit.

I have considered our income position a number of times over the last year or so, and the diversity seemed to pretty much assure that we would continue to have at least 1 out of 3 major incomes at any given time.  I think that is still true, but I’m not as sure as I used to be.  It is unfortunate that it has taken a serious financial crisis to finally drill into my head the need for a substantial emergency fund.

To that end, I think that I will hold off on moving from cash to equities, at least for now.  But, if the market starts to rise quickly, soon, I know I’m going to feel a bit sick over not taking advantage of it when I had the chance.  What’s interesting is that people are often told to take on as much risk such that they will still be able to sleep at night.  For me right now, I feel like not taking on sufficient risk is going to keep me up nights…

What about you?  Are you hanging on tight to the roller coaster ride?  Did you get out of the market already?  Are you plowing cash in?  What would you do in our situation?  Let us know in the Comments Section below!