Marketplace

A Trip to France

Question: My wife and I are planning on going to France next summer and have been saving money for the trip. But the exchange rate is making our dollars less and less valuable overseas each month. What is the best way to help preserve our buying power? Thanks, Pat, Lakewood, Ohio

Answer: I'm jealous. France in the summer is delightful. The food. The history. The scenery. Okay, enough of that reverie and on to your financial question.

As I'm writing this, the dollar is near a record low against the Euro. At the moment it doesn't appear that the downward pressure is going to let up anytime soon. Factors include the weakening U.S. economy, low interest rates, and the reconsideration by a number of oil-rich Persian Gulf nations and a handful of dynamic Asian economies of their reliance on the dollar.

However, some Wall Street currency mavens believe that the Euro value has gotten way too high relative to the dollar, and there could be some narrowing of the exchange rate by the time you take your trip. Problem is, economists don't have a good model for forecasting currency values. It's anyone's guess what the dollar will be worth by summertime.

First, I would plan on spending more in France. It's simply going to be a more expensive vacation. Next, I'd consider taking out a hedge or insurance policy against the dollar going lower by putting some of the trip money into a short-term certificate of deposit denominated in Euros. For instance, Everbank of St. Louis, essentially an Internet operation that is part of First Alliance Bank in Jacksonville, Fla., offers CDs in a number of foreign currencies, including the Euro.

There are a number of other options, ranging from mutual funds that invest in overseas short-term money market type investments to exchange traded funds that concentrate on Euros. For instance, Rydex Investment offers an ETF that allows you to speculate on the appreciation of the Euro and the depreciation of the dollar. However, investments like this are risky.

Remember, you're taking out an insurance policy so if the dollar improves against the Euro within your travel time frame, you'll take a slight financial hit. Of course, if the dollar stays weak or even heads lower, the cost of your trip will go up a bit more.

Either way, I bet it will be a memorable trip.

12/13/07 by Chris Farrell

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Payoff Mortgage?

Question: I now have saved $50,000 and my husband has saved $40,000 in the bank. We pay mortgage each month about $1,000 and we still have more than $120,000 to pay for 29 years.

My question is: should we pay off our mortgage within the next year? If not, what should we do or invest with our savings? How will we plan for the future? We have no kids. I have a retirement plan, 403 with my employer but my husband has nothing. My husband plans to retire next year but I'll keep working. Thank you very much. Sue, Grand Fork, North Dakota

Answer: I think in the heart of every homeowner burns an intense desire to say goodbye to the bank for the last time and own a home free and clear. It's a wonderful moment, and if you have the money there's nothing wrong with paying off the mortgage to live debt free.

That said, I'd like to throw a couple of cautions against your getting rid of the mortgage right away. For one thing, you're putting most of your financial eggs in one basket -- a home. That's another way of saying that your financial health is now dependent on how one asset performs in coming years and, as we are witnessing right now, home prices can go down as well as up. I'd prefer that you build up a well-diversified portfolio in cash, stocks, bonds, commercial real estate, commodities, and international equities. Your home will then shrink as a percentage of your net worth. Once you've built up a well diversified portfolio, then by all means pay off the mortgage.

What else could you do with the money? I'm glad to see that you're participating in your retirement plan at work. One idea is to create a long-term portfolio in a taxable account. This way you can access the money without paying the 10% penalty you have to fork over if you tap into your retirement account under the age of 59 1/2. To keep your annual tax bill down, I'd recommend investing a chunk of the money into broad-based equity index funds. For example, with an equity index fund that mirrors the Standard & Poor's 500 or the Wilshire 5000 you'll pay very little capital gains tax every year since there isn't a professional money manager churning the portfolio every couple of weeks. You will, however, pay taxes on dividend payments and when a company is taken out of the index, say, through a merger or acquisition.

Another tax saving tip is to put the fixed income portion of this investment into I-bonds. Inflation is every saver's nightmare. Even if inflation averages a low annual rate of, say, 2% to 3% over the next quarter century, that's still enough to depreciate the value of a today dollar by nearly half. The I-bond is a savings bond, and it shares many of the same attractive investment features as its better-known cousin, the Series EE savings bond. There are no commission costs imposed when buying or selling I-bonds. I-bonds are sold at face value (up to $30,000 a year) and earn interest for 30 years, although you can sell after five years with no penalties. You don't pay any taxes on the investment until you cash in the bonds. There's no credit risk since the I-bonds are backed by the federal government. Its value adjusts to take into account changes in the Consumer Price Index, and you're also paid interest on your money. (You can get much more detail about I-bonds at www.savingsbonds.gov.)

A final point: It seems to me that you're at a major transition point with your husband retiring and you continuing to work. It's at times like this that a fee-only certified financial planner (CFP) can help you create a financial blueprint for the next stage of life. The planner would help you look at your whole portfolio, your stream of income and savings, and match your finances to your lifestyle goals. And you can run by the CFP the ideas I've suggested to see if they will really work for you. Good luck.

12/14/07 by Chris Farrell

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Naming a beneficiary

Question: I listened with interest about your story of the military man who is investing in the Thrift Savings Plan and was happy to hear your high review of the plan. My husband is a rural letter carrier and has been investing in TSP since he became eligible. When it became available he transferred all funds to the life cycle fund and is very pleased with the performance so far. Every quarter we download and print the statement; we noticed that he has NO BENEFICIARY DESIGNATED. Would that lack of specific designation cause problems for me (as his wife of 34 years) and/or our adult children in the event of his death? Or should that designation be changed as soon as possible? Thank you if you are able to respond to this question. Gail, Springville, Pennsylvania

Answer: As his spouse, the lack of a beneficiary designation shouldn't cause you any trouble. Federal law says that the spouse is automatically the beneficiary of a pension plan, including a thrift savings plan.

However, in general you should still fill it out, especially if you want to include your children as beneficiaries. It's simply a good habit to fill out the beneficiary form which, by the way, overrides what's in your will. (And if you don't have a will, please get one.).

The insurance company USAA recently listed in its newslatter three mistakes to avoid when it come to naming a beneficiary. They are worth keeping in mind.

1) Name an individual rather than an estate as beneficiary. The tax code provides named beneficiaries with more tax-friendly choices than when they receive an IRA through probate.

2) Failing to keep your designation current. It pays to review and update your beneficiaries whenever there is a major life event, from divorce to the birth of a child to retirement.

3) Don't name minor children as beneficiaries without appointing a custodian. Minors can't own investments outright, so they need an adult to act as custodian until they reach the age of majority.

12/17/07 by Chris Farrell

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Education: Debt or Savings

Question: My husband is planning to start a two-year Master's degree program next fall (2008) which will cost about 24,000 total. We have enough money in savings to pay for most of the tuition, but I wonder whether it would be wiser to take out student loans for all of it and let our cash stay in the bank to earn interest for those two years. (We have no other debt other than a mortgage.) Suzan, Minneapolis, MN

Answer: To some extent this is a personal choice or preference. Some people in your financial circumstances just don't want to take on any debt. They prefer to pay out of savings. Clearly, that's a sound option.

But I'd like to argue for borrowing some to most of the money needed for the Master's program while leaving your savings alone. The reason is that when your husband graduates you could face a number of different choices, including moving to another city for a better job. Now, that may or may not be in the cards, but by keeping your savings your decision about what to do won't be constrainted by money when he graduates. And since there is no prepayment penalty with student loans, you can always pay off the debt at that time.

12/18/07 by Chris Farrell

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Safe Savings

Question: Hello, My husband and I are hoping to buy our first home in about 8-12 months, and we are trying to figure out how best to invest our extra cash in order to make a down-payment.

We expect that we'll be making a 20% down-payment of about $100,000 when we buy. We've currently got about $25,000 in cash to invest. In addition, we'll invest everything from our salaries after living expenses -- we're a lawyer and a graduate student.

Here's our question: What's the appropriate investment vehicle? We need a high-yield, low-risk product that won't smack us with serious tax penalties. We're thinking a short-term bond fund or a CD? Or should we simply park the money in our high-yield checking account, which gets 4% interest? What say you? Cheers, Elizabeth, Washington D.C

Answer: Bravo. I like your conservative financial strategy of putting the money in a low risk product. Since you'll need the money soon, you're right to seek an investment that preserves the value of your $25,000 in savings while making some interest on it.

I have two votes: First, the high-yielding checking account you have that is paying 4% is just dandy in today's market. Plus, your money is fully protected by the Federal Deposit Insurance Corporation (FDIC). There is no risk of you losing the money to bank mismanagement or a disastrous fallout from the current credit crunch.

Second, you could park the cash in a money market mutual fund at a brand-name mutual fund company. You'll earn a higher rate of interest on your money than you would in most bank savings account, and if short-term interest rates go up, you'll participate in the higher rate. The money is easily accessible, too. Most money market mutual funds, for example, offer limited check writing.

However, in the current troubled economic and financial environment I would favor a money market mutual fund made up primarily of U.S. Treasury bills and short-term government agency debt. It's the most conservative choice (and you'll pay for the increased safety through a slightly lower interest rate) but this way you to avoid the risk of any unwelcome subprime debt showing up in the mutual fund. The federal government and its agencies won't default on their debts.

12/19/07 by Chris Farrell

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The AMT

Question: Hi folks, We were just sitting here listening to Chris Farrell say that the AMT should be eliminated. We agree that changes need to be made to this tax, but don't understand why it should be totally eliminated. The problem it was originally designed to solve probably still exists. Chris said the reason the situation is bad now is because it was not indexed to inflation. So why not just make the change so that the income levels affected are in line with those originally targeted? Obviously, there would still need to be another source of revenue for the government. But why do away with it completely? Paul and Carol, Joelton, Tennessee

Answer: It's a good question. Now, I'm in the camp that believes the AMT or Alternative Minimum Tax came about for a good reason: Evidence in the late 1960s that some of the nation's wealthiest families weren't paying any tax thanks to shelters and deductions. I don't think it was good tax policy or public policy that these wealthy families escaped Uncle Sam's tax bill. And I certainly don't like it that once again Congress and the White House have just agreed on another "patch" to limit the reach of the AMT into the middle class rather than get rid of it through fundamental tax reform.

Anyway, why not just restore the AMT to its original purpose? The reason is that I am increasingly skeptical of targeted income taxes. The current tax system is an abomination. The federal income tax code is a legal maze riddled with exemptions, exclusions, deductions, credits, phase-ins and phase-outs--as well as the AMT. Taken altogether, billions of dollars are spent on accountants and lawyers every year. Billions of hours are spent struggling to fill out forms. Tax economist Joel Slemrod at the University of Michigan has estimated that it costs taxpayers some $100 billion a year to complete their returns. That's no chump change, even in a $14 trillion economy.

Instead of redesigning or overhauling the AMT, I favor radical tax simplification. The basic idea is simple: Lower marginal tax rates by broadening the tax base by limiting exemptions, deductions, and credits. For instance, economists have designed an income tax system that eliminates every loophole except for charitable giving and a home mortgage credit (as opposed to the current home mortgage deduction).

A White House appointed blue chip panel proposed a radically streamlined tax system several years ago; sadly, not enough attention was paid to its recommendation. A simpler, progressive tax code with lower rates would benefit all taxpayers and also ensure that the nation's wealthiest families pay taxes.

12/20/07 by Chris Farrell

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Finding A Financial Planner

Question: Help! How do I find a good financial planner? Someone who I can sit down with and show my entire portfolio, with stocks, IRAS, and real estate investments and who will understand all of it and help me crunch all the numbers so I can clearly see my different options to get out of the mess I got myself into?! Samantha, Venice, California

Answer: This may be unfair, but my first question is do you really need a financial planner? My overall bias is that for most people the answer is no--at least not until you can do most of your financial planning on your own. Here's why: One of the biggest money mistakes people make is to simply turning their money over to a professional and assume they'll do all the work. That's a recipe for trouble and disappointment.

Still, some of us truly need to talk to a real person rather than interact with a computer screen. In your case, talking to a knowledgeable person will help you make sense of your options going forward. There are other reasons why it can pay to work with a professional. A number of people find that their finances are too complicated to deal with on their own. Another good reason is time. Our lives are hectic, the law is constantly changing, and we'd like to work with someone we trust. And for many of us, tapping into the expertise of a planner makes sense when we are facing a major life transition, such as retirement.

There are several ways to find a financial planner. The best method is networking. Talk to neighbors and colleagues that use a financial planner and get their recommendations. You can also go to the website of the National Association of Personal Financial Advisors at www.napfa.org. Another resource is the Financial Planning Association at www.fpanet.org.

I'm definitely biased toward fee-only planners with a Certified Financial Planner (CFP) designation. That gives you confidence that they're professionals well-versed in the basics of the business. They also invest in continuing education. In addition, with a fee-only planner you get objective advice unsullied by commissions.

Once you have found several potential fee-only CFP candidates, carefully check out their references and learn whether they deal with people in your income bracket. Assuming that most check out and that they are all ethical, how do you choose? At that point, the deciding factor is which financial planner you're most comfortable with. After all, this is a person who is going to be working with you on the financial details of your life--the good and the bad.

12/21/07 by Chris Farrell

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Happy Holidays

Happy Holidays. I'm taking a break Christmas Eve and Christmas. I'll resume answering your questions next Wednesday.

12/22/07 by Chris Farrell

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Medical School

Question: I recently inherited a small life insurance from my mother's passing. There are no guidelines how I should spend the money, but it was hinted that I use it toward going to medical school. I'm about a year and a half away from starting med school, and wanted to know the best way invest the money until then. Is it actually better to invest the money until I graduate or to use it to help offset loans? Or should I, in all reality, use it to save for my retirement... something I have yet to do? Patrick, Detroit.

Answer: You're about to make the biggest investment in your life--a medical school education. And you'll reap a stream of healthy income off your career choice.

The cost of a medical school education is high. The average debt of graduates with debt from the class of 2006 (including pre-med borrowing) was nearly $131,000, according to the Association of American Medical Colleges. And 72% of medical school graduates have debt of at least $100,000. With numbers like these, I'd lean toward following your mother's wishes and use the money to limit how much you need to borrow for your medical education.

If you agree, I'd park the money in a low risk investment that preserves the value of your principal and earns you some interest. It isn't sexy--far from it--but boring money market mutual funds from a brand-name financial institution, or U.S. Treasury bills bought directly from the Treasury (www.treasurydirect.gov) would meet your needs. Plus, with inflation running at a 4.3% pace over the past 12 months, an additional advantage of these two investments is that they will match or even beat the rate of inflation with minimal risk.

Now, you could use the savings to limit how much you borrow. You could also husband the money until you graduate and then pay down debt. I lean toward the latter choice simply because it gives you a bit more financial leeway when you graduate. Either way, you'll reduce the debt burden from getting a medical education.

As for your retirement, I would look at getting a medical degree as the key investment in your long-term retirement savings plan. It will give you the income and the means to enjoy the latter stages of life.

12/26/07 by Chris Farrell

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Emergency stash

Question: I'm newly married and trying to put together a plan for budgeting and saving for our future. The book I've been reading suggests emergency savings of at least 3 months take-home pay, in addition to reserve savings for planned expenses. Additionally, it recommends keeping this money in a money market fund, or index fund with check-cashing privileges. In the past you've recommended index funds over other sorts of mutual funds. Can you talk more about this, and suggest some places to look? I will be making fairly small deposits, at least at first. Jeremiah, San Francisco

Answer: The advice to put the cash in a money market mutual fund is conventional and non-controversial. To use the Wall Street jargon, it's a very "liquid" investment, meaning you can write a check off your money market fund when you need funds in a pinch.

What I don't get is the index fund advice. When I talk about index funds, it's usually a broad-based domestic equity index fund, an international equity index fund, or a bond index fund. In each case, fees are razor thin and your investment will match the performance of the underlying index. However, these are riskier investments--you don't want your emergency savings tied to the movements of the stock or bond market. I think it's a great idea to put money into index funds in a taxable account, but I would reserve it for long-term savings, such as a child's college education.

12/27/07 by Chris Farrell

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The Falling Dollar

Question: How can I hedge against the falling value of the dollar? I have 400K in TIAA/CREFF, half in TIAA and the other half split between Social Choice stock/bond fund and inflation linked-bonds. I plan to retire in 2 years and am only concerned about capital preservation. TIAA/CREFF has no Euro or other international bond funds. Thanks, Chris. Dave

Answer: In one sense you don't have to worry about the decline in the value of the dollar relative to most currencies unless you plan on traveling to, say, Europe. The dollar is weak against the Euro, and you don't get very many Euros when you exchange your dollars at the bank. But almost everything else you do in terms of buying, borrowing, and investing is in dollars here at home.

That said, the big concern from the declining value of the dollar is that it will contribute to rising inflation pressures. Over the past 12 months consumer price inflation has been increasing at a worrisome 4.3% rate. Much of the rise comes from higher food and energy prices, but a weak dollar isn't helping.

Inflation is the enemy of savers. Take this example from John Brennan, the head of the mutual fund giant Vanguard. "If you are 60 years old today and spend $50,000 a year to maintain your lifestyle, you would need to spend about $90,000 when you are 80, assuming a low 3% average annual inflation rate," says Brennan. "At 5% inflation, you'd need about $133,000 a year."

The good news is that you're already making the smart investment to protect yourself from the declining value of the dollar and the risk of higher inflation: Inflation-linked bonds. These are fixed income securities that preserve the value of a dollar--plus interest--against the ravages of inflation. These bonds adjust to changes in the consumer price index.

The best way to preserve capital is to invest in inflation-indexed bonds, especially the ones offered by the U.S. Treasury. Right now, investors will do better owning 10 year Treasury inflation-indexed bonds versus a traditional 10-year Treasury bond if consumer inflation exceeds an annual rate of 2.3% over the next 10 years.

12/28/07 by Chris Farrell

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Happy New Year

Happy New Year. I'll be back answering your questions in the new year.
Yours,
Chris

12/31/07 by Chris Farrell

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