Saving for retirement vs. your child's college education

A question from formspring: 

What is more important-saving for my retirement or saving for the kid's college education?

A: That all depends on your financial situation but if you're like most people the answer is your retirement.

The reason is simple: your child can borrow for education but you can't for retirement. And depending on your age, the years between new and your children's college graduation could be critical for you in terms of building a nest egg and adding to it with the appreciation you earn on your retirement investments. For example, if you weren't investing in stocks or mutual funds at all from late last year through the first quarter of 2010, you likely missed out on huge gains that could have offset any losses you took in the 2008 market crash.

Every parent wants to see their child do well but you have to remember that life will go on after your child has finished school and started a career. Not having retirement savings could not only harm you, but harm the start you're trying to give your children in life -- imagine how hard it would be for them trying to take care of you in your later years absent the retirement savings you could have socked away?

Keep the used car or get a new one?

Two interesting questions from one person I got on my formspring:

My 2003 Lexus runs reasonably well, has 83k miles. I think it will need about $2k in repairs & it will be fine. I do mostly city driving. I owe about $8k on it. I could pay it off, sell it, get newer used car & still have nice bit of cash left. Thoughts?

If your car is still running well and you only owe $8k , I'm baffled at why you want to get another one. Unless the plan is to sell the car for enough to buy a newer car in cash, then this plan doesn't make sense.

But to do that, you'd have to sell your car for $8,000 plus the price of the newer car. I know Lexuses have decent resale values, but I have a hard time imagining you selling a 7-year-old car with almost 100,000 miles on it and which needs $2,000 in repairs for enough to be able to pay off an $8,000 note AND still buy another car. Either you need to go into used car sales or that plan is seriously flawed.

Ok, you sold me. Keep car, pay it off, get it fixed. Done. So what do I do with the rest of the cash, around 40k? Can I have just 1 splurge? Please?

If you've got $40 grand in cash laying around, that's great and it's perfectly fine for you to buy yourself something. People get it twisted by thinking that folks who advocate frugality don't want you to spend ANYTHING. That's not the case; it's just that most people spend more than they take in, and don't save much at all.

Feel free to do something nice for yourself WITHIN REASON. Don't blow $25k of it in a weekend. Give yourself a (small) budget and have some fun.

After that, though, you need to consider what in the world you're doing with all that cash laying around? How much of an emergency fund do you have? If the answer's none, you need to stash enough of that money away in a savings or money market account to cover your expenses for several months in the event of a layoff or emergencies.

Already got an emergency fund? What about retirement? If you're not investing in a 401(k) and don't have an IRA, you need to start putting money away for your retirement.

If you've done both of those things, you're in good shape, but you can always afford to be in better shape by stashing most of that money away either for a rainy day or toward a home or some other goal you have.

Take baby steps before you start investing

These are the questions I get most: young people who want to become investors but aren't sure where to start. And typically my answer is always the same: begin at the beginning.

Q: I am interested in investing but I do not know where to start. Is it better to do online investing? Or have a financial advisor? How do you find out when upcoming new projects are letting people invest in their company? Is it better to invest money into mutual bonds? insurance policies?

A: That's actually several questions but I'll try to give a thorough answer. As I said, I often get questions about how to start investing but many people aren't really ready yet. Pouring money into stocks, bonds, mutual funds or other types of market-based investments isn't a good strategy if you haven't done the financial basics.

What are the basics? Budgeting, assuring you're living within your means, having significant cash savings and investing in your company's 401(k) or other retirement plan if they have one.

My question to the reader who asked the question is have you done ALL of those things? Do you live by a strict budget under which you can see that you have money left over after all your living expenses to devote to investing? Are you living within your means every month or do you have revolving credit card or other consumer debt that you need to pay off? How many months could you live off what you have stashed in savings? Are you putting a significant amount into your 401(k) retirement account?

If not, begin at the beginning. Remember that becoming an investor isn't about how quickly you can get rich, it's about building assets over time. Of course the earlier in life you can begin that process, the better, but trying to pour a large amount of money into stocks, bonds or mutual funds before you have enough money saved up to last even a month in an emergency is a lot like trying to run a marathon before you can walk.

Take your time, crawl first and be sure your desire to become an investor doesn't make you trip all over yourself.

Things for new investors to consider

Today's question from tweeted to me by @JNeedHisScrilla (love that handle):
What is the best direction to go for a first time investor with limited funds?
That's a tough question to answer, because like choosing a mate or a place of worship,choosing a smart investment strategy is intensely personal. Where you put your money, and how much of it you put there, should reflect your own goals, resources and time frame. There are as many reasons for investing, and kinds of investments, as there are people with things to spend money on.

But here are some common reasons first-time investors get in the game and things you should consider:

• To save for a first home. Usually, putting your downpayment savings into stocks or mutual funds doesn't make sense because of the risk of losing money. But if you're young and not planning on buying for 5-7 years, you might be able to weather a downturn and still see a return on your principal before you have to touch that cash. You probably still want to keep those holdings separate from any other investments.
• To save for retirement. This is likely to be the first introduction to investing that most young professionals will get. You start your first job and they hand you your benefits packet and that includes information on the company's 401(k) plan and an enrollment form. Read that information from first word to last, and then enroll at the maximum level you can afford to. If you're working and not in your company's 401(k) or other retirement plan, there's really no point in thinking about any other kind of investing.
• To save for a business. To build capital for a business. The same rule as saving for a home downpayment applies: don't put money into the market that you're going to need over a short time frame. But if you don't think you'll be hanging out your own shingle for at least five years or more, this might be an option.

In any event, the best thing you can do before you begin investing is to learn as much as you can about investing. Do you know the difference between equities (stocks) and fixed income investments (bonds)? Do you know what a mutual fund's expense ratio is (and do you even know the difference between funds and individual stocks?). Before diving into any major endeavor, you need to know as much as you possibly can to mitigate your risk.

Good luck.

photo courtesy of freedigitalphotos.net

I'm unemployed. Should I take money from my retirement account?

Another good question from twitter:

Don’t raid your retirement even to put food on the table when you’re out of work. Agree or disagree?

For the most part, I agree. That is if by "raid your retirement", you mean take an early withdrawal from a tax-deferred account like a 401(k) or 403(b). With a few exceptions like taking cash for a downpayment if you're a first-time homebuyer, early withdrawals from these plans do far more long-term damage than short-term good. For one, you lose the principal (the amount you take out) and thus any interest you'd make on that money over the years. That could be a substantial loss if you're in your 20s or 30s and still have two decades to pile on that interest.

Second, by taking an early withdrawal, you'll pay a heavy penalty on top of being immediately assessed taxes on money that you otherwise wouldn't pay until after you've retired, when your tax rate would be lower anyway. If you're in dire straits now, think how you'll feel when the government's tax bill comes at the end of the year.

That said, if taking money from your retirement is your only option and you're really, seriously on the verge of starving, it's probably better to not starve. But for most people who are still capable of finding some kind of way to put food on the table (have you filed unemployment or sought part-time work??), this is an absolute, positive last-resort of all last-resorts.

Now is the time for young people to become investors

Are you investing right now? You probably should be. In fact, despite all the fear about the stock market and people's 401(k)s tanking, investing is one of the few areas I think people should be cutting back on now.

Why? For the same reason I tell people (at least young people), they shouldn't stop contributing to their 401(k) retirement accounts: the stock market is on sale and the bargains are better now than they have been in years. A few examples (disclaimer -- these are EXAMPLES, not stock-picking advice. Choose your own investments carefully based on your own financial situation):

• On Jan. 20, shares of PNC Financial Services Group Inc., which last year bought National City Corp., closed at $22 a share. Nobody liked bank stocks then (most investors still don't). But yesterday PNC closed at $40.93, meaning if you bought then, you'd have doubled your money.
  
• Last October, I interviewed an investor who told me he thought he was getting a bargain by buying Procter & Gamble stock while it was trading in the $57 range. Right now, PG is trading at about $49; it's worth less than it was then, but it's a strong company (everybody needs toilet paper and detergent) who's shares are going for a bargain.

This month's Black Enterprise magazine has a cover story on investors in their 20s who have picked up on this and are taking the opportunity to make long-term investments while stocks are cheap. What about you? Are you investing now, or sitting on the sidelines until the market picks up.

60 Minutes: older workers might not get to retire

Today's post was supposed to be an update on Bobby and Aleks' house hunt but I get so many questions about 401(k) plans that I had to post about last night's episode of 60 Minutes. They looked at the devastating impact a tough economy has had on many people's retirement investments and gave a good history on 401(k)s and how they came to be so prevalent. It was sobering: many people in their 50s are finding out that they aren't going to be able to retire when they wanted to, or at all, because their portfolios have lost tens or even hundreds of thousands of dollars in value. What was also angering was the discussion of how 401(k)s were intended to be part of a "three-legged stool" of retirement finance that also included pensions and social security. But greedy companies have all but eliminated pensions and the government can't pay for social security for too much longer, what with all the wars it has to finance and the bank bailouts that are more important than your retirement.

Definitely watch the video, but keep a couple things in mind: before you get ready to pull out of your 401(k), remember that your situation is probably very different from the people depicted. People over 50 should definitely have lessened their exposure to losses by moving most of their investments over to bonds and cash, not the stocks that have taken such a beating. And if you're in your 20s, 30s or even early 40s, you still have time to make up what you lost over the past 18 months.

It's a recession; should I stop contributing to my 401(k)

A question from a reader:

My company recently suspended its 401(k) match. They used to match up to 6 percent of employee contributions -- now they match none. I'd taken advantage of it (and built up a nice start to my retirement savings) in recent years, but after they announced the match suspension (a few weeks ago) I lowered my contribution back down to 3 percent.

So here's the thing: it's a recession. And my money is getting increasingly tight (we're not even going to TALK about the pay cut they want us to take here). I know I should be saving, but is it okay if I just eliminate my contributions all together and have that extra 3 percent stay in my paycheck? What should I be thinking about (beyond setting myself up for the future)? What do you suggest I do? I'm 25: I would like to buy a new pair of shoes or something, not just work so I can pay my bills.

I understand your concern. Most of the questions I get are about 401(k) plans and with the economy being what it is being worried makes a ton of sense.
But I can never advocate making a short-term decision when looking at a long-term problem. I'll use myself as an example: I started my first 401(k) maxing out but quickly figured out I had a cash flow problem. What I should have done is what you did: rolling back my contribution just enough to still get the company match, but no less. What I did was pull completely out for about a year or so. that was a mistake.

Why? Because when you're young, what matters is not how much money you're putting in, it's how many shares you accumulate. The principle of compound interest is at work, meaning you accumulate enough shares on a regular basis, and over the long term those shares increase in value and give you a better return on your investment.

Right now (and I've said this before), the market is on sale. Everything is cheap. And while that doesn't make every stock or mutual fund a good investment, it does mean that accumulating shares of good stocks or funds is easier to do. So even though you're worried about the economy, to an extent the turmoil in the markets works in your favor. But that's only if you keep accumulating shares by contributing to your 401(k).

There are a few questions you should ask yourself. How much money would really go back into your paycheck after taxes if you stop making your 3 percent contribution? I don't know how much you make, but it's entirely possible that the tax benefit you lose by not contributing would negate any after-tax cash you'd get back. Would it really be worth it if you'd have to pay an extra, say $75 in taxes if all you were getting back after tax was $125 each pay? Find a 401(k) calculator and do the math before you act.

Also, I know you want to live and enjoy your youth but are you sure the ONLY place you could cut back is your 401(k)? If you really want a few new pairs of shoes, why not try and shift some other discretionary spending. Cut back on cable, maybe? Fewer meals out? Not as much long-distance driving on weekends? Whatever it is, there's usually some discretionary money that you can shift around to make a difference.

Last, do you have any credit card debt? If you do, think of the money that's going to pay off whatever you bought as your discretionary spending right now. If you're still paying off some shoes you bought last year (with interest), does it really make sense to take money from your nascent nest egg to have fun with. Think of your credit card balance as the bill coming due for fun you've already had but didn't pay for.

Should you trust your bosses with my 401(k) money?

Happy Monday. While I was on vacation last week, I got this question from a twenty-something journalist who just became eligible for her company's 401(k) plan:

I just got my 401(k) paperwork and learned that the family that owns the paper has an investment company that picks where the money is invested and we have no say-so.

I thought 401(k)s are supposed to be flexible. Also everyone I know at Gannett and McClatchy papers can pick where they want their money to be invested. Does this have to do with them being owned by big media companies? I'm sure none of this changes whether or not I should sign up, but how can everyone else's newspaper give them some choices and we have none.
PS: All my co-workers seemed very uninformed about why this is the case.

I wouldn't trust that. I'm not sure I've ever heard of a 401(k) that didn't allow an employee control over where their asset allocation. In fact, many people complain that they don't understand all the choices available to them. While that can be a problem, it's a good one: the point of options in your 401(k) plan is to allow you to tailor it to your needs based on the length of time you have before retirement and your own risk tolerance for potential losses. Leaving that up to your company to decide means they could invest your money in places that may be good for them but awful for you. Besides, your employer doesn't decide what you do with any of the other money it pays you, so why should they decide where to invest your 401(k) money?

You can open your own IRA and keep control. Remember Enron!

401(k) week, day 3: Why now is a bad time to pull out

If another person asks me if they should get out of their 401(k) because the stock market is down, I'll slap 'em. No,really, I'll do it.

Why? Because it's such a simple thing to understand: would you rather shop for clothes at full price or when they're on sale?

Ok, then. Right now just about the entire stock market is on sale. That scares people because they're watching the value of their 401(k)s drop. What they don't recognize is the opportunity to beef up their accounts by buying more shares at a steep discount.

Say you bought five shares of Company X for $20 each last year. If those shares dropped to $10 each and you sold them, you lost half your investment.

But say you held them, and put in another $100. At that price you get double the number of shares you originally bought. If the price goes back up to $25 your $200 total investment is now worth $375. Remember, every time you put money into your 401(k), you're buying shares of the stocks, bonds or funds you chose when you did your asset allocation.

Get it?? Of course, it doesn't always work that way. Company X could be a dog, and if you bought it as an individual stock, you're at greater risk of losing the whole investment if things go bad. But in a 401(k) your money is spread among many investments (this is called diversification). That plus the long time you have until retirement works in your favor in terms of surviving short term losses and accumulating shares that will grow in value.

The other thing to consider is that if you're not at least 59-1/2 years old and you withdraw or close your 401(k), you immediately pay taxes on the money you take out, plus an early withdrawal penalty. So if you think you're losing money now, imagine if you pull out and then have to pay the government on top of that.

Long story short: unless you've got a really, really, really, REALLY good reason, stay put. You'll be fine.

401(k) week, day 2

Yesterday, I mentioned asset allocation. Today a definition.

Asset allocation basically refers to where and how you invest you money. It's important to have the right allocation in a 401(k) because that will determine how well you take advantage of the

There are all kinds of investments and asset categories, but to keep it simple, I'll just divide them into two: those that are more aggressive we'll call "growth" and less aggressive we'll call "safety".

As a general rule, money you'll need soon should be in a 'safety' vehicle. An example is a bank savings account. Money there is insured and easy to access. On the other hand you won't earn much interest on it. It's only there for safe keeping.

In a 401(k), the less time you have left before retirement, the safer you want your money to be. Shifting your asset allocation toward things like bonds or money market funds makes sense. (Your plan's manager will likely use a term like "capital preservation" or "liquidity" to describe this asset class). Those are relatively low-risk investments that generate little return but also have little risk for losing any of what you've saved up.

On the flipside, if you're in your 20s, 30s or early 40s, you should be more aggressive by investing in growth assets. Stocks, international funds and the like carry more risk than safe investments, but come with bigger potential rewards. Your 401(k) manager will likely refer to these as "growth" or "aggressive growth" vehicles. Since you won't be touching the money for 20 years or more, you have time to make up any losses.

If all that still sounds like jibberish, the investment manager of your 401(k) should have an easy answer for you. Call them up and ask if they have pre-allocated portfolios set up based on the year you're supposed to retire. Most plans do this. If you don't know anything about how to invest your money, at least you know your age; someone who's 25 today would reach retirement around the year 2049, so they could simply ask their plan's manager if there is a portfolio pegged to that year, and allocate most, if not all, of their money in that.

Up tomorrow: why now is the absolute, positive best time to be putting money into a 401(k).

401(k) week, part 1

Just like I promised last week...

Here's a quick primer on what a 401(k) is and how they work:

• A 401(k) is a retirement investment account sponsored by employers for their workers. (If you work for a government agency, it's probably called a 403(b). If you don't know if your company offers one, ask someone in HR today.

• 401(k)s are named for the section of the tax code that gives them their most attractive features. First, the money you put in comes out of your paycheck pre-tax, which reduces your taxable income for the year. Second, that money grows tax-deferred, so you don't get hit with a tax bill at the end of the year like you would other investments. (Note I said tax-deferred, not tax-free. You'll eventually pay taxes on the money but not until you withdraw it, which shouldn't be until you retire, when you'll have a lower income and lower tax rate).

Many companies match a percentage of what you contribute. Say you make $50k a year and contribute 10 percent, or $5,000 a year to your 401. If your company matches 3 percent, that means they're giving you an extra $1,500 a year, without taxes, toward your retirement.

A couple of common misconceptions to clear up:

• You own and control your 401(k), not your company. That means you decide which stocks, bonds or funds will be held in your account at all times, and that you keep all the money you put into the account and any gains you've made if you leave for another job.

• There is something called "vesting", which basically means that you only keep the money that your company matches if you stay employed there long enough. The vesting period is usually between three and five years. If you leave before then It's their way of trying to guarantee they're getting a return (your work) on their investment (their money in your retirement account).

• Whether you make or lose money in your 401(k) does NOT depend on how well your company's stock is doing. That is unless you've loaded up your account with company stock, which you should never do (think Enron). 401(k)s are made up of investments you choose based on how long you have before retirement and your risk tolerance (that's called "asset allocation" and I'll explain it tomorrow). But don't worry if you're working for a company that has a low stock price. If you have a good mix in your 401(k) account, it won't matter at all.

Back tomorrow with more. Any questions, post in the comments section

401(k) bootcamp

Yesterday I got another example of why financial literacy should be mandatory in schools and provided as part of a benefits package from employers. A woman in her early 20s found me online yesterday and had a line of questions a mile long about 401(k)s.

The questions were riddled with clues about her lack of knowledge of basic investing principles: What's the difference between a 401(k) and an employee stock purchase plan? Does the value of my 401(k) drop if my company isn't doing well? (Not unless all you have in your 401(k) is shares of your company's stock). The market's bad; shouldn't I be taking money out of my 401(k) and putting it into a regular savings account? (No, that'd be one of the worst things you could do.)

Beyond that, she wasn't sure what investments she had chosen for her 401(k), whether they were appropriate for her age and risk tolerance or even how the money she put in translated into shares in funds or stocks.

I'm glad she reached out and I'm not in any way belittling her for having the questions she had. But what's frustrating is that at a time when the country can ill-afford to have it's educated, employed, high-income potential young people financially unawares, our educational system and employers continue to do students and workers a disservice by equipping them to make money but not educating them on what to do with it next.

So all next week I'm doing a 401(k) bootcamp on the blog, going over basic terms and principles of a 401(k) plan, and answering any questions you might have. Now's your chance to learn if you're not sure, so don't be afraid to speak up.

What the hell's an expense ratio and how much will it cost me

Blog reader Nadia in New York emailed me a question about mutual funds' "expense ratios." Sounds boring, I know, but if you own mutual funds (and you do if you're contributing to a 401(k) ), keep reading.

Nadia's question:

I am doing a direct rollover and the fund now has gone from 0 to 0.73% expense ratio. I called to inquire about how that is going to effect my pennies once everything is rolled over. I was told there would be no fees and he patted me on my head and that was that. This 0.73% means something...I work too hard for my money to be lining the pockets of fund managers.

Nadia, here's the deal: expense ratios are basically the percentage of a mutual fund's assets paid to fund managers for, well, managing the fund. Another way to look at them is as your costs of ownership. There are several types of fees that go into the ratio but unless you're interested in the minutia, all you need to worry about is the overall ratio itself. The Motley Fool has a good primer on expense ratios here.

Now, a fund having an expense ratio is not a bad thing necessarily; somebody has to pay the fund manager. That said, you don't want a fund with a ratio that's exorbitantly high compared with its peers in the same category. That'd be like buying milk for $5 a gallon when you know milk is on sale across the street at two gallons for $4.

Do some research on the kind of fund you're rolling your money into and what how its expense ratio compares with others that it competes with, and of course, pay attention to performance. And now that you know the basic definition of these fees, you should call your adviser back and ask some more informed questions.

I hope this was helpful to Nadia or anyone else out there who didn't understand what that expense ratio thing was on their mutual fund statement.

Look at my 401(k) losses so you can ignore yours

I'm starting off with an issue people have been worried about for a month: what's up with the value of my retirement account?

It's easy to see why: October was the stock market's worst month since I was 10 years old. The volatility probably won't end before '09, given the bleak forecast for consumer holiday spending not to mention Wall Street's unpredictable response to the election.

But I've been giving those who ask me if they should pull out of their 401(k)s the answer: Hell No!

Never jump out of the market at the bottom unless you absolutely have to, which is not the case for the majority of 401(k) owners. If you're in your 20s, 30s or early 40s, you're working with at least 20 years before you can withdraw money from a 401(k) without paying heavy penalties, so you'll lose MORE money by withdrawing now than by leaving your money alone and letting the markets correct themselves. And the market will certainly turn around between now and 2028, so chill.

Since the easiest way not worry about a 401(k)s is to ignore your own losses, I'm doing you a favor and posting my own losses below. When you get tempted to look at your own balances just look at how much I'm losing, thank God you're not me and forget about your own troubles.

My IRA lost 16.7 percent of its value in October;
My current 401(k) lost 8.3 percent;
My old one, which I still need to roll over, lost 17.1 percent;
Since May, my net worth has taken a dive of about 51 percentage points, mostly on retirement account losses.

Ain't it great not being me?

Welcome to the Money Corner

If you read my old blog, thanks for following me over here. Newbies, here's an intro: I'm Keith Reed, a business reporter and economics commentator. I started blogging two years ago to share my answers to questions friends asked about how the economy, their spending habits, investing, saving and the like.

I'll take questions from anybody because I think there are few things more needed in America than more financially literate people -- check your credit card balance if you disagree.

Here's what I'm not: a day-trader, stock-picker or financial adviser giving out professional investment recommendations. Instead, this blog is a forum for your concerns and curiosities about money. I'm here to share my common sense opinions, informed by the hours I spend interviewing and interacting with entrepreneurs, analysts, executives and everyday people.

Hope you like the blog and find it useful.