Marketplace

The Social Security Do-over

Question: I began receiving Social Security payments at age 62. Now I'm 66, and I've read that I can pay this money back to the government and get significantly larger checks. Bad idea? Peter, Ashland, OR

Answer: It all depends on how the numbers work out. But in many cases it can be a savvy financial move. I recently did a brief story for Business Week on the basics of taking the Social Security two-step.

How to Retire Early, Then Change Your Mind

Call it the Social Security do-over. If you retire early and take a reduced monthly benefit, you can change your mind, reapply, and get the bigger payments that go to those who wait to collect benefits.

The catch? After filling out Form 521, you must send the government a check covering the benefits you've been paid (without interest or adjusting for inflation). "Everyone is free to do this," says Laurence J. Kotlikoff, economics professor at Boston University and head of financial-planning software company ESPlanner.

He ran numbers for a couple who retire at 62, have $300,000 in savings, and an additional $100,000 each in retirement assets. They want their money to last until they're 100. If they apply for benefits at 62, each gets $17,921 a year.

Fast-forward eight years. Had they waited until age 70 to file, they would get $31,005 each, for a total of $62,010 a year. To get those higher payouts at this point, the formula requires them to pay $118,957 each. Yes, that's a big check. But to get that same payout by buying the cheapest commercial annuity would cost 40% more. When you include earnings from the couple's other assets and factor in their 30-year time horizon, Kotlikoff calculates that their annual aftertax spending can go from $58,765 to $70,420.

Professor Kotlikoff has written a more detailed explanation of the financial maneuver. You can find it at www.esplanner.com/illustrations.php, and click on "Double Dip on Social Security."

04/01/08 by Chris Farrell

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Saving Too Much

Question: I would like your opinion on the retirement goals set by my investment firm. I'm 54 years old and have no debt at all. My house, car, etc, all paid in full. I have a job I love, making $90k annually plus I still have a small income from a former business - approx $10k annual. My house is worth approx. $340k and I have $350k invested in mutual funds through an advisor (Wachovia - fee based plus commission). I've had a miserable history with advisors - this group is my third. I'm currently putting 56% of my job salary into savings, plus I have 401K and a pension through my employer.

The 56% is getting a little tough but my advisor says to be in the "safe range" at retirement, I need to be this aggressive. I don't know if they are telling me the truth or if they just want me to beef my portfolio so they can charge a higher fee.

I would like a little breathing room and enjoy life a little. I worked hard to get everything in this comfy state but now I can't even have a small splurge occasionally... Advice? Please? Kate, Charlotte, NC

Answer: You're savings 56% of your income? No wonder you feel strapped. I'd really loosen the spending reins, and enjoy yourself. Obviously, in an email communication I can't know all the ins-and-outs of your finances. But by any measure, setting aside 56% of salary in savings is steep. I'm puzzled--no, I don't understand at all--the advice to save such a large percentage of your income. What am I missing?

Put it this way: The old financial planning advice was to salt away some 10% to 15% of income in savings. In recent years that figure has been upped to 15% to 20%, largely reflecting greater volatility in the markets and higher healthcare costs. But that's still way below 56%.

I don't understand the reasoning behind saving any more than 10% to 20% of income unless there is a particular goal in mind. What's more, unlike most people your age, you don't have any debt. Let's not turn the smart idea of saving for tomorrow into meaning little more than hoarding cash and collecting regrets today. Saving to save is just as bad as spending to spend.

04/02/08 by Chris Farrell

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From CDs to Mortgage?

Question: I have a $240,000 fixed rate mortgage at 5.75%. My monthly PITI payment is a little under $1,900/month. And I get by OK on my retirement and cash flow from a rental. I'm 58 and single, and I'm able to file an itemized return.

Now that CD rates are falling, I was wondering if it made sense to divert some of the expiring CDs' funds into the mortgage. My mortgage is recastable, so I can lower my payment for every $10,000 I chunk into it. What's more, I can't get anything like 5.75% on any safe investments. I'm gun shy of The Market right now. What's more, I have also been turned off by most stocks' stingy dividends. I do have some mutual funds and some utility stocks.

I could throw-in up to $100K and still have around $200K in cash left in CDs (not including IRAs). That amount would take the mortgage down by around $700/month. Basically, that extra money would provide me with extra spending money or money to pay off the mortgage principal. I have around 25 years left on the mortgage.

Does this make sense from the perspective of "tax savings?" I would have less taxable income at non-preferential rates from the CDs, but I would have a smaller interest deduction. Is this deduction worth it? Anonymous.

Answer: I think you have already answered your question. There is nothing wrong with paying down your mortgage early and, you're absolutely right, you lock in a 5.75% rate of return. And while the tax deduction helps, it isn't that valuable compared to the what you will save in interest. If you scroll through my previous answers on this question you'll see that I worry about homeowners putting too much of their savings into one asset--their home--and not enough into stocks, bonds, international securities, and cash. But you have accumulated a good amount of savings, and accelerating payments on a mortgage (or any debt) is a sound strategy for the risk averse--especially in this market.

04/03/08 by Chris Farrell

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Savings for Child

Question: my wife and I just had our first child. We are wondering what sort of investment/saving plan would be the best to start for him. We are looking to invest $100 a month. Thanks. Michael, Seattle.

Answer: Congratulations. First of all, you can't go wrong putting money on a regular basis into a tax-sheltered 529 college savings plan. That said, I have one other thought. How about putting the monthly savings into a broad-based equity index fund with razor thin fees (such as the Standard & Poor's 500 index, Russell 3000, Wilshire 5000, and the like). The savings is in your name. In 16 to 18 years, you'll have accumulated a nice pot of change. You can spend it on your child's college education. But maybe your child will get good scholarships. Then you can spend the money on yourselves, or perhaps create the family trip of a lifetime. You gain a lot of flexibility with this approach.

04/04/08 by Chris Farrell

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Stock Market Risk

Question: I listen to your podcast every week and enjoy your show, but one thing continues to confuse me. Often someone states that investing in the stock market will return 7% or 9% per year over the long haul. That may be historically true, but what if this is no longer true? What, for instance, is the average return over the past decade? If it isn't 7 or 9 percent, shouldn't Marketplace Money at least consider that a long term investment in stocks may not necessarily result in gains? Yours, Rob, Erie, PA.

Answer: You're right. Stocks have languished for long periods of time. For instance, in 1966 the Dow Jones industrial average was at 744 and in 1981 it was at 776. The stock market then turned up for a long-term bull market run.

Most people saving for their retirement have a meaningful definition of risk; it's the chance of a meager and demoralizing reward from investing in stocks or, even worse, actually losing money "Stocks are risky because the good returns might not cancel out the bad ones. Instead, stock prices (or real stock prices) might deteriorate even over very long periods of time, impoverishing the investor. I do not expect this, but it could happen. That is what I mean by risk," wrote Laurence B. Siegel, director, investment policy research for the Ford Foundation in an article several years ago "Thus risk is not short-term volatility, for the long-term investor can afford to ignore that. Rather, because there is no predestined rate of return, only an expected one that may not be realized, the risk is the possibility that in the long run, stock returns will be terrible."

Still, doesn't time also eliminate that risk? The probability of doing poorly in stocks does shrink with time; but it doesn't disappear. Think of it this way. Stocks wouldn't beat out bonds in the performance sweepstakes if there wasn't a chance that bonds could do better than stocks for lengthy periods. Indeed, before 1900, stocks lagged railroad bonds and matched commercial paper returns. Since 1871, there have been many ten year periods when bonds outperformed stocks.

Nevertheless, the wrong lesson for anyone chastened by the recent global financial crisis is to steer clear of equities because they are too risky. The rewards are worth the risks. Put it this way: If you can envision in ten years time that the U.S. economy still remain a leader among the major industrial nations, full of dynamic companies and bold entrepreneurs, then you will want to own stocks. Similarly, if you believe global economy will expand despite stomach-churning fits and starts, then you'll want a slice of international equities. The right lesson is diversifying your money across a variety of assets. Miguel de Cervantes in Don Quixote de la Mancha put it this way: "'Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket."

04/07/08 by Chris Farrell

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A Big Downpayment?

Question: I am searching for a new home (main residence) and was wondering whether I should use a huge downpayment and dent my assets or take a large loan and keep some assets, considering inflation, decreasing mortgage rates, and current turmoil. Thank you -- I love you show. Thank you for not printing my name. Anonymous.

Answer: I wonder what you mean by a "huge downpayment"? The traditional figure of a 20% downpayment is good benchmark. I wouldn't strap myself for cash--a home take money to maintain--to far beyond that percentage. And with the economy is recession or near-recession I'd want to have a healthy cash emergency safety net. Call it your "just-in-case" money. You can always accelerate principal payments on your own if it makes sense.

04/08/08 by Chris Farrell

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Conflicting Advice? Not

Question: A couple of days ago, in response to a questioner's inquiry about some ideas which had been presented to his mother at a seminar, you dismissed charitable remainder trusts as one of several risky and wacko investing ideas. Yesterday, you suggested that they were a legit combination of charity and retirement planning. A number of years ago I purchased an annuity which combined life insurance with a traditional annuity, which I don't believe can be gotten today. After several years (required to hold for at least 7 years), I cashed it in, taking a 20 year payout at guaranteed interest, eventual payout to exceed my then current value of 25% appreciation, with the balance to be paid to my beneficiary. It seems that a charitable remainder trust combines this sort of annuity with a donation. Why is it not a good idea? Your advice seems conflicted. I had been considering changing my will to create a CRT for the small amount of giving which I feel I can afford, as it seemed to be a valid combination of giving and investment. Nick, Glover, VT

Answer: I'm a fan of charitable remainder trusts. The same goes for charitable gift annuities. In both cases, you support a charity. You get some nice tax breaks. And you can set up a steady stream of income for life. In answering the question where I made some negative remarks it was about the kind of financial conference where lots of high-fee high-cost peddlers of products get together to hawk their wares to unsuspecting and unsophisticated families. .

So, to be clear, products like charitable gift annuities can be a critical part of smart estate planning. However, there are a number of financial and emotional factors to consider before buying a charitable gift annuity and similar financial arrangements (such as a charitable remainder trust and a charitable lead trust). Top of the list are the many estate planning issues to think through, from your income stream to your children's inheritance. It's also important to realize that the decision is irrevocable. You can't wake up one morning and say to yourself, oops, I made a mistake. That's why in most cases sensible philanthropic financial planning requires professional guidance.

Still, the time spent researching the product and seeking out professional advice can be worth it. Seems to me you made a good move.

04/09/08 by Chris Farrell

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Equity Investment Life Insurance?

Question: Chris---We have recently been advised by a financial consultant to begin to invest in an Indexed Universal Life Insurance Contract, also called an equity investment life insurance policy. After reviewing our financial situation with retirement in mind, the advisor told my husband and me, 55 years and 58 years of age, respectively, that we should stop putting our discretionary income into the qualified plans that we both have at work. He argues that we have enough in our qualified plans to maintain our current lifestyle and that we should begin to look for investments that shelter income from taxes for the future. The vehicle he suggests is an "equity investment life insurance policy". He argues this vehicle is a "Roth look-alike" and will allow us to grow our investments tax free, including the earnings that accrue in the account, and it will be tax free when it is withdrawn. The theory is that because tax rates will continue to grow higher, it would be better for us to be paying the taxes now on the money rather than after we retire, as current tax rates for us likely will be lower than future tax rates. Since our qualified plans defer taxes, he argues we have more tax deferred income than may make sense for us. The type of vehicle he suggests would have a cap on how much it would earn in a given period of time but it will also not go below the start level in any given year..... So, for example, we might buy a policy for $500,000 which would then have a monthly fee associated with it. He argues that we should not be overly alarmed by the monthly fee which includes all fees for transactions, etc. He argues we are paying mutual fund companies plenty of fees and the fees associated with this vehicle won't be higher than the total we're already paying various mutual fund companies.

We are cautious people and will not rush into any major change without thoroughly investigating its pros and cons. I told the guy we'll seek multiple points of view, as he will make his money from selling us on this product. Any guidance you can provide will be appreciated. Greg and Carol, Minneapolis

Answer: I'm not a fan of these plans, although they are a niche product that can work for some people. The fees are high (much higher than equity index funds, bond index funds, Treasury securities and the like). The equity formula is a complicated black box, which runs counter to my "keep it simple" mantra. And you can limit your downside portfolio risk through diversification, inflation-protected securities, and the like.

If it were me, and if I had the assets you have, I would hire a fee-only certified financial planner to look 1) at your overall financial situation and 2) evaluate this policy proposal in light of your assets, liabilities, goals and desires. Yes, a CFP isn't cheap. I could be wrong, but my bet is that she'll come up with a more cost-effective way to build a conservative portfolio.

04/10/08 by Chris Farrell

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Channeling Warren Buffett

Question: Mr. Buffet discusses "Fanciful Figures..." in the Berkshire Hathaway 2007 Annual Report (pp. 18-20). He asserts that the compounded annual gain for the DJIA in the 20th century was 5.3%. He goes on to say that in order for both individual and institutional investors to match a 5.3% compounded return on investment during the 21st century, the DJIA, "...would need to to close at about 2,000,000 on December 31, 2099." This is a possibility which he rejects.

He goes on to point out that any financial adviser suggesting that an investor expect 10% annually from equities in this century are "...direct descendants of the queen in Alice in Wonderland."

Are corporate pension managers, the financial planning community, and those of us investing in stocks, bonds, ETFs, etc., kidding ourselves regarding our true ability to predict and save for our financial future? Or are we better off emulating those who take on 120% LTV subprime mortgages and living on minimum payment credit cards? Tim Longmont, CO

Answer: I love Warren Buffets annual report. Any saver or investor can profit by reading the Letter from the Chairman. You can read them at www.berkshirehathaway.com. I think his message is conservative. Yes, invest in the markets (and for most people he has written that smart investing means putting stock market savings into a broad-based equity index fund). Diversify your portfolio. Stick with quality companies. Save, don't take on frivolous debts (yes to a mortage, no to credit card debt). And keep your expectations realistic when it comes to investment returns--after taxes and after inflation. But don't go the highly leveraged route. That's a path for financial catastrophe for most of us.

04/11/08 by Chris Farrell

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Downsizing

Question: My wife and both turn 50 this year. Our son is graduating college and our daughter enters college this fall. We are downsizing into a smaller home, purchasing with cash. We'll then sell our current home. I've looked forward to being "mortgage-free" for some time, but several of our friends suggest losing the tax advantage is a bad financial move. Chris, what is your opinion? Tom, Charlotte, NC.

Answer: First of all, from a financial point of view it's really smart to make a downsizing move while you're still working. You'll save a lot of money--no mortgage, lower property taxes, cheaper utility bills, and so forth--and you can salt away at least some of that money for later on. In a sense, it's a smart savings strategy. Secondly, I don't think the mortgage deduction is all that important to your bottom line. Sure, it helps. But it's far better to enter your Golden Years owning a home without a mortgage. This way you have a solid equity foundation for your overall portfolio. Go for it

04/15/08 by Chris Farrell

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Managing Money for 10 Years

Question: My husband, Gregg, runs a non-profit literary arts organization called the Citylit project (create link to www.citylitproject.org). He inherited a nice car from someone he published, Adele Holden, a poet/English teacher who grew up during the segregated 1930s on the Maryland's Eastern Shore, scene of Maryland's last lynchings. When her memoir book published, she bought a black Infiniti I-30 cash outright since, she explained, Gregg would be driving her all over the state to readings and events. He did, and when she passed away she left him the car. We plan to donate the proceeds from selling the car to CityLit Project and publish African-American poets, likely young emerging poets, given Adele's passion for teaching. So my question is, what's the best way to invest $10,000 for the most gains which also allows access to proceeds within the next 10 years? Thanks. Marik, Baltimore MD.

Answer: This is a wonderful story, and a terrific use of the money. Now, in terms of investing the $10,000, the key concept is the relationship between risk and return. It's an axiom of modern finance that the only way to create the opportunity to earn a higher return is to take greater risks--and vice versa. The trick will be to mix and match investments to create a portfolio that gives you the chance for a decent return for the amount of risk that makes sense to accomplish your goals. Another factor to consider is how much of this money will you draw on during the 10 year time horizon? The more you want to tap into it on a regular basis the more conservative the portfolio choices become.

One way to structure the portfolio is to build a layer investment cake. The foundation would be "cash", which is Wall Street jargon for short-term securities, such as a three month to 1 year certificate of deposit, Treasury bills, money market mutual funds, and the like. With these investments your principal is safe, you'll make some interest on it, and the money will be easily drawn on when you need it. You could boost the income you earn by then putting some money into longer term fixed income securities. Since you have a 10 year time horizon, I would consider a adding a final layer of stocks through an broad-based equity index fund such as the Standard & Poor's 500. That would be your riskiest investment, but it would also offer the best opportunity for growth. You can play around with the percentages (or skip the stocks altogether) depending on how much--or little--risk you're willing to take.

I'm curious if any readers have other suggestions about how they might manage the money. Please send them in the comments section.

by Chris Farrell

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A Rollover IRA

Question: I was recently hired for a job in the public sector, working for the state of New York. My previous job was in the private sector. My 401(k) from my previous job is still being administered by my former employer, and it's now worth about $108,000.

The benefits administrator of my present employer has told me that I am not allowed to roll my 401(k) into any pension or savings plans that my employer offers. What are my options for doing something productive with my 401(k), instead of just letting it sit there? Tim, NY, NY

Answer: A rollover IRA (Individual retirement Account) is designed for circumstances just like yours. It's a routine transaction. First, figure out what financial institution offers the mutual fund options and services you'd like. They'll have the forms online for making a rollover IRA, but I always recommend calling the 1-800 number and ask for a human being to walk you through the process. The reason is that you want to make sure that your retirement savings are transferred institution to institution. In other words, you don't touch the money. It goes from your 401(k) to the financial institution you've picked for your IRA. This way you preserve the pension's tax shelter.

04/16/08 by Chris Farrell

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Switching Life Insurance Plans?

Question: I am a single, 40 year old woman, no dependents. I got a New England Life Insurance policy about 13 years ago - not for a payout if I die prematurely, but as a way to save money for retirement. I have someone who has been helping me invest my money for these past 13 yrs. but recently sought a second opinion. This second opinion wants to take my money out of my current company and put it with Northwestern Mutual Life. I will lose $286 in a transfer fee, which isn't a big deal if it is a smart move. I will also lose ground as I am now 40 and will be paying a higher 'mortality rate' (using the wrong term but I hope you know what I mean). The man who recommends this move says Northwestern Mutual is such a superior company that the long-run benefit will overcome the short-term loss. What should I do? Thanks - Marti, Chicago, IL

Answer: For most of us, the main reason to own life insurance is to financially protect a loved one from our untimely death. That's usually a child, but it can be a parent or a partner. (Life insurance also plays a critical role in the estate planning of the wealthy.) Although you're accumulating savings, life insurance is not an especially efficient or cost effective retirement plan. It pales next to a 401(k), 403(b), IRA, Roth-IRA and other retirement savings plans--or just building up savings in taxable accounts, a home, and other alternatives. There's no rush, but I would go through your finances and see how life insurance fits into your overall plan, and decide whether it makes sense for you to keep a policy or not. It's dated, but I still find it a useful introduction to the topic is "Smarter Insurance Solutions" (Bloomberg Personal Library) by Janet Bamford.

That said, I'm concerned about this specific proposed shift. Your concerns and questions are legitimate. New England Life is a good, reputable company. It has a AA/stable rating from Standard & Poor's, the rating agency. Northwestern Mutual is an excellent company with an even stronger balance sheet at AAA/stable. Still, New England Life is no fly-by-night operation. It has a blue-chip balance sheet. (If it didn't my advice would be different.) You've owned the policy long enough that you're now really getting the benefits of the savings component. My fear is that this shift is not to your financial benefit but to improve the commission earnings of the "second opinion".

That's my worry. One quick, cheap way to check out whether this move makes financial sense for you is to contact the Consumer Federation of America. It offers a life insurance evaluation service. You can find the details at here. The service helps insurance consumers decide whether to buy a cash value policy or term insurance, decide among two or more cash value policies, and whether an existing cash value policy is worth keeping. The cost for the analysis is $70 for the first illustration.

04/17/08 by Chris Farrell

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Remodel Home?

Question: We are currently faced with a dilemma. My wife and I bought a home years back with the eventual assumption that we would outgrow it and have to move into a larger place. Since that time, we have had two kids and fallen in love with the neighborhood. Our kitchen is outdated, with buckling countertops, our furnace is over 30 years old, and we've got no room to store clutter that comes along with kids. (Legos can be particularly painful to bare feet.) We'd really like to stay put and get an addition and replace the dated things that need replacing, and have a place for storing everything. Our worry is now the best time to do these things? The economic down turn... or recession has us concerned. We have very little debt, other than the current mortgage. We are able to pay our bills and save a little for retirement and college for the kids. Are we making the right decision to add on to the house? Rob, Bel Air, MD.

Answer: Whew, I can relate to the pain of walking on Legos. I think the current housing turmoil means more people in circumstances like yours will pick remodeling over moving. (Plus, as you say, you love the neighborhood.) The remodeling industry boomed along with the surge in real estate prices, according to Harvard University's Joint Center for Housing Studies. The remodeling market in 2007 breached $290 billion, up from an annualized $85.3 billion in the final quarter of 1997. It's during these boom years that remodeling horror stories became common currency among homeowners, from contractors doing shoddy work to walking away from incomplete jobs. Although the remodeling market has held up well compared to the housing market, activity will slacken if history is any guide. While the cost of drywall, composites, and other materials is up, labor is plentiful and many contractors are eager to keep their crews working. There is more room to negotiate than before, but I think the real gain is better work for the price paid.

That said, if you do go the remodeling route remember that it will only "pay" as a long-term investment. You'll lose moeny if you end up moving soon. The general rule on renovations is that you will only recover about 40% of the cost of any work done, with kitchens and bathrooms having the highest return on your money and luxuries like swimming pools the least. I'm sure you've already gone over the details with your contractor, but you can check out the numbers at Remodeling Online . Again, it's clear you don't want to end up with too much debt, so prioritize the project and figure out what you might want to do later. So, assuming you stay conservative with your finances, owning a remodeled home in a neighborhood you love will add to the quality of your family's life. And that's worth a lot.

04/18/08 by Chris Farrell

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Green Cards and Social Security

Question: I have 2 questions: 1: Is it true only US Citizens can collect SS when they retire; Green card holders do not qualify?

2: I have a Net Worth of about $300K, making up of Cash (60%), Stocks (25%), real estate (10%) and 401K(5%). Should I have a personal financial planner to handle my finances? If so, do you have any recommendations, and how much would it cost? Thank you. Ed, Seattle, WA

Answer: Green Card or Permanent Resident Card holders pay Social Security taxes, and receive Social Security benefits when they retire (as long as they've worked for 10 years before retiring). Immigrants can get more information at the Social Security Administration's website.

Your second question is a much bigger one. Briefly, my bias is no, you don't need to hire a financial planner. That is, not until you can do the basics of financial planning on your own. No matter what, you'll need to educate yourself first. Here's why: Over the years, one of the biggest mistakes I've seen people make is turning their money over to a professional and assume they'll do all the work. That's a recipe for trouble. And it takes time to find a good planner that you'll want to work with.

However, if you'd like a quick check up that focuses mostly on your portfolio (rather than the whole estate), Ive become a fan of the financial planning services offered by several of the major mutual fund companies. The fees are minimal, and the ones I have looked at are steeped in modern portfolio theory and sound personal finance practice. For instance, they won't try and get you to heavily trade stocks and bonds. You do have to be comfortable working over the phone and by email. The advice is limited, so I'd take it with a grain of skepticism. But it's also a nice way to check your assumptions and preferences.

04/21/08 by Chris Farrell

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Saving for College

Question: On average, we save about $1000 a month. $500 of it goes to a 529 college savings plan for our son (he's about two years old). $200 goes to two Vanguard index funds (Total Stock Market and Total International) in our regular taxable account. And we put $300 in a money market fund with our bank.

The money market is now at about $7000, and we realize we don't have a good option to invest that money. We don't want to have the money sit in a money market account. Certainly not for 16 more years. Neither do I feel comfortable putting all of it in 529. Hence, I am looking for an option that (1) provides growth opportunities, (2) has low tax impact, and (3) has some mechanisms built in for age-appropriate auto-(re)balance.

In the last show, Chris mentioned tax-managed mutual funds as an option for semi-long term tax efficient investment. I looked at Vanguard's tax-managed funds. They all cost quite a bit to start, $10,000. So this doesn't seem to be a valid option.

What other options are available? I suppose that I can buy ETFs at a discount on-line brokerage as a way to boost tax efficiency and hold diversified investment stocks. I am not sure if, given the amount of dollars we are talking about here, ETF would be a good choice, e.g. the amount of saving on tax efficiency would offset other shortcomings of ETFs. I have a hard time thinking about or comparing ETFs with index funds. In addition, I will have to do age-appropriate asset re-allocation myself with the ETF funds. Because that would take time and discipline, it might not be an attractive option 10 or 15 years from now.

Another thought is to buy a Vanguard target retirement fund that sets my son's college entrance year as the retirement target year, say 2020. With this, I at least can have stochastic asset reallocation as a means to reduce portfolio risks. But I have no idea how tax efficient that fund is. And it probably is not. Thanks. Key, Cary, NC

Answer: Your question is extremely thoughtful, and just reading how you're thinking through the various options and trade-offs might help someone else decide what to do.

Fact is, I like what you're doing: a mix of a 529 plan, index funds and a money market fund. I hope that the index funds and money market fund are in your name so that if your son gets scholarship money, you can tap the savings for your retirement. I prefer the index mutual funds over ETFs because the former are ideal for adding money on a monthly or quarterly basis without paying the brokerage fees or commissions. So I would take some of the money market fund money and put it to work in the index funds.

One other thought: You could buy some I-bonds to add into the mix. The fixed 30-year rate of interest on the inflation-protected savings bond is currently 1.2% per year (plus the actual rate of inflation). But it will almost certainly fall when the rate is reset on May 1. The limit per person is $5,000 in electronic form at www.treasurydirect.gov and another $5,000 per person in paper form at banks. Still, you get a guarantee that a dollar saved today will be worth a dollar plus interest 16 years from now when your child goes to college. And the money compounds tax-deferred until you cash it in.

04/22/08 by Chris Farrell

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Money Market Savings Accounts

Question: Chris -- You mentioned money market mutual funds a couple times on last week's show. Are money market mutual funds the same as money market savings accounts? Can you get them at banks, or just brokerages? Are they still as liquid (make deposits, withdrawals) as money market savings accounts? Thanks -- I appreciate all of your and Tess's advice. Brian, Auburn, AL

Answer: Money market mutual funds and money market savings accounts are similar in many respects, but there are critical differences between the two. A money market savings account at a bank typically pays a higher rate of interest than a regular savings account. The account usually has a higher minimum balance requirement and limitations on the number of withdrawals a month. A money market savings is insured up to $100,000 by the Federal Deposit Insurance Corporation (FDIC). In other words, if the bank goes belly up, your money is safe (assuming you're under the insurance limit).

The same isn't true with a money market mutual fund. There is no FDIC insurance backstopping the account. In return, you'll get a slightly higher interest rate with the money market mutual fund compared to the money market savings account. Still, money market mutual funds are among the safest investment options available to individual investors. There are two simple ways to reduce risk with a money market mutual fund. First, invest with a brand-name financial institution with the resources to backstop a money market fund if it gets into financial trouble. Second, choose the most conservative fund option. It's the one that is comprised of mostly short-term U.S. Treasury securities and federal agency debt. There's no reason to chase higher yields by taking greater risks with this money. You want your principal safe and earn a decent interest rate.

04/23/08 by Chris Farrell

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Canceling Credit Cards

Question: I would like to cancel some of my credit cards that I no longer use. I'm concerned about identity theft, and about fees charged on cards even if they're not used. Is there any reason I shouldn't cancel these cards? Thank you! Dennise, Santa Cruz, CA.

Answer: In the perverse world of credit scoring, closing these accounts will lower your overall score for awhile. I still think it's smart to get rid of the accounts for the reasons you mention. So, if you have a major purchase coming up in the next year, say, a home or a car, I would hold getting rid of the credit card accounts until after you've borrowed money to buy a car or home. You'll get a better interest rate this way. Once the purchase is behind you, cancel the cards. Of course, if there isn't a big borrowing in your near-term future, get rid of them right away.

04/24/08 by Chris Farrell

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Spousal IRA

Question: I am a 30 yr old man with a 9 month old son and a stay at home mom to take care of. I have started contributing to a Roth IRA this year. I maxed out for 2007 and have contributed $3000 towards 2008. I plan to invest in low fee index funds and have invested in the Vanguard Emerging Market Index Fund and the Vanguard Balanced Index Fund. This should cover the whole world!

I have played it safe with my Roth IRA even though I consider myself more aggressive than others. I would like to trade stocks, hopefully keep them for more than a yr to escape the high taxes but in the current market situation there are times I feel like selling stocks that are not doing too well.

My question is: Can I open a Roth IRA for my wife even if she doesn't work. If I can, can I actively trade stocks in that account but opening a Roth-IRA with TDAmeritrade or any other discount broker. Will it all be tax free? Wouldn't it be a good strategy to avoid taxes if you want to actively trade? Pradeep, Chicago, IL.

Answer: Yes, assuming you file a joint tax return, your wife can open up a Roth-IRA in her name. She funds it with after-tax dollars for up to $5,000 in 2008 (the limit is $6,000 for those age 50 and above). The so-called "spousal" Roth IRA and traditional IRA is the one exception to the rule that you need earned income to contribute to an Individual Retirement Account. (Technically, there is no such thing as a spousal IRA, but the phrase is used as descriptive shorthand in the financial services business.) By the way, all the other Roth rules still apply, such as the compensation phase-outs. It doesn't read as if that's a problem for you and your wife this year. But for any couple that doesn't qualify for a Roth, a traditional IRA funded with pre-tax dollars is always an option. There are no restrictions except the amount that can be contributed with a traditional spousal IRA. It's a smart move for your wife to open a retirement account..

But we are going to part ways on trading stocks in the Roth IRA (or any IRA). To be sure, trading in the retirement account won't trigger any tax consequences. But when saving for retirement the savvy strategy is to invest in a well-diversified portfolio with minimal trading and razor-thin fees. This approach substantially increases the odds of doing well over time. That's why I like the portfolio you have in your Roth.

Now, if you want to test your stock-picking wits in the market by trading stocks, I'd do it in a taxable account not a retirement account. Yes, you'll end up paying taxes on gains, but you'll also minimize any tax hit with your losses since Uncle Sam underwrites your bets that go bad.

I would also strongly encourage your wife to manage her retirement account on her own. It's a good idea for everyone to understand how to invest money in the markets.

04/25/08 by Chris Farrell

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Questions answered on air for April 26-27

On this week's Marketplace Money, Chris and Tess answer questions about rising property values, dealing with a collection agency, transferring savings bonds and switching life insurance.

Listen to this week's segment

Continue reading "Questions answered on air for April 26-27" »

by Jeffrey Long

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Blending Finances

Question: Hi Chris, My girlfriend and I will be graduating from Cal's City and Regional Planning Master's program next month. We will also be moving in together.

Neither of us has lived with a partner before. We're thinking about buying a car. And we're wondering if you have suggestions for any books or resources that will help us have a harmonious financial relationship together. At this point, we're not sure whether we will be getting married but still want to thoughtfully and logically think through our communal finances. Justin, Oakland, CA

Answer: Congratulations on you and your partners thoughtful approach to money. To me, how money is handled defines one of the big differences between living together and being married. Even when married couples strive to keep their finances separate, money mingles over time. And for most newly married couples the decision to set up merged accounts is deliberate. But when you're living together it makes sense to keep money separate most of the time.

Keep the lines of money communication open. Don't let any problems or issues fester. Establish a regular money meeting for paying bills and talking over finances. And whatever system you and your friend decide on for splitting and paying the bills-- keep it simple. Now, on your specific question of a car, it's easy enough to divide insurance, maintenance, and gas bills. But what about ownership? For instance, who gets the car if you split up? And if you buy together you should have a contract that spells out obligations.

Ownership is a legal issue. A good resource for looking into the options for a car contract between unmarried couples is the Nolo.com guide Living Together: A Legal Guide for Unmarried Couples. As you can gather from the title, Nolo's book is written from a legal perspective. For insight on handling the basics of household money as a couple, I like Ruth Hayden's For Richer, Not Poorer: The Money Book for Couples. It's geared toward married couples, but there is practical advice for any couple.

04/28/08 by Chris Farrell

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Coverdell College Savings

Question: I have 2 Coverdell IRA's for my 2 children, to which I contribute what I can. I've heard that the program is set to expire in 2010. 1) Is this true? 2) Does this mean I have to get the money out and close these accounts before 2010? My children are both under 10 years old. Brian, Ann Arbor, MI

Answer: You're right that a number of the college savings attractions attached to the Coverdell will end in 2010. I'm not really sure why Congress improved the 529 college savings plan in 2006 but left the Coverdell vulnerable. But it did. For instance, the Pension Protection Act of 2006 made withdrawals from 529s permanently tax free when the money goes toward qualified educational expenses, like tuition. What's more, the sums invested in 529 plans aren't considered a student asset in the financial aid formula calculation.

In sharp contrast, the Coverdell didn't get legislative protection. No, upgrade passed in 2001, such as raising the contribution limit from $500 to $2,000 and allowing tax-free withdrawals for K-12 expenses, are still slated to expire in 2010. The Coverdell will be then much less attractive choice for college savings. For instance, right now you can make tax-free withdrawals from a Coverdell to pay for college and still take advantage of the Hope or the Lifetime Learning credit. After 2010, you'll be forced to decide which benefit to take, the tax free withdrawal or the credit.

What to do? If you like your Coverdell accounts you can continue to make contributions into them. If the Coverdell bells-and-whistles do expire, you can always roll the money over into a 529. (It's a tax-free rollover.) You can gamble that Congress will get rid of the 2010 sunset date. Or you can open up a 529 plan for your children. No matter which choice you make, your savings will compound tax-deferred and your children will benefit from your thrift. I just wish Congress would stop all this nonsense about sunset provisions. It makes savings more complicated than it should be.

04/29/08 by Chris Farrell

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Socially responsible Investing

Question: I'd like to invest in a green mutual fund, one that develops wind and solar energies, electric cars etc. I've been looking at Winslow green growth. Any thoughts or suggestions? Kate, Sheridan, WY

Answer: I looked up the Winslow Green Growth fund on the www.morningstar.com website. As of writing this column, the fund's year-to-date return was down -22.50%. Its one-year return is -5.60% and its 5-year return annualized is 17.73%. Its net expense ratio is 1.45%, which is on the high side. (According to Morningstar fees on green funds range between 1.25% and 1.98%.)

I typically prefer index funds that cover a range of industries and charge low fees, and there are a number of "green" index funds. Once you've created a broadly diversified portfolio and you then want to place a bet on a sector or a fund or a company with a small percentage of your portfolio, well, by all means go ahead--have some fun. If you're interested in doing more research about socially responsible investing two good websites are www.socialinvest.org and www.socialfunds.com.

The biggest rap against the movement is the belief that marrying personal values to an investment portfolio cuts into returns. In other words, doing good and making money don't mix. I don't agree. A number of studies suggest there's little difference between pooling money to make money and pooling money to make money and express values. This came home to me in a series of papers by Meir Statman, a finance economist at Santa Clara University. Among his conclusions, the risk-adjusted return on socially conscious index funds is roughly comparable to the Standard & Poor's 500 index and the performance of actively managed socially responsible mutual funds is about equal to their conventional mutual fund peers. (You can read his papers on the subject at www.scu.edu/business/finance/research/sristatman.cfm.)

One note of caution: Socially responsible funds tend to have high fees that cut into returns. So while it always pays to shop around it's especially true in this industry.

04/30/08 by Chris Farrell

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