Don’t put all your eggs in one basket

One of the things I try to do with my investment portfolio is diversify my holdings among several different investments. I primarily invest in index funds because they have the lowest fees and generally cover a wide range of options. One thing I stay away from is investing in my company’s stock.

It’s not hard to find examples of people who lost their life’s savings after investing heavily in their company - only to watch it go belly up. Prime examples include Enron, WorldCom, and dozens of DOTcom’s that had inflated prices before the world realized they were only speculations and the bottom fell out.

Another reason is that your job is probably your main source of income, so it already represents a huge portion of your total income producing assets (remember, you can consider your ability to create income as an asset). In high school my Dad told me the reason he didn’t invest in his company stock was that if the company was doing well, chances are he would have a job that would be going well. He chose instead to invest in index funds and similar holdings which has done well for him.

What about company matching?

Sometimes companies give matching 401(k) funds as stock, or they fund pensions with company stock. If that is your only choice, then you should probably take it. After all, it is free money, right? But you should be careful that the amount of company stock you own doesn’t become too heavily weighted based on your total portfolio. You might look into selling some of it when possible to maintain a balanced portfolio - jsut beware of possible tax implications.

What about company discounts?

Some companies offer Employee Stock Purchase Plans that allow their employees to buy stocks at a discount. Sometimes this can be a good deal. If you know your company and think it is well valued (and you aren’t trading on insider information), then making a stock purchase can be a good thing. Just remember not to own too much company stock relative to your total holdings.

However, you should only buy your company’s stock based on its intrinsic value and not only because you are getting a discount. After all, a 10% discount on something that is over-valued means you might be breaking even at best, or at worst losing money.

Owning company stock isn’t bad - it’s all about balance

Just like everything else, balance is the key. Your career is already heavily invested in your company, so focus your other investments in places that will give you the best return. The last thing you would want to happen to your company is another Enron type situation.

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I can:

• Leave the assets in the current 401(k) plan.
• Roll the assets into an IRA
• Roll the assets into new employer’s 401(k) plan.
• Withdraw the assets in a lump sum.
• Transfer the assets to a qualified annuity.

So let’s look at my options:

1. Leave 401(k) assets in current plan with former employer.

The easiest thing to do is leave your assets in your current employer’s plan. It takes no action on your part. However, if you have less than $5,000 in your account, your employer can close the account and return your money to you. If you have more than $5,000, you can usually keep your money in the account.

Possible Advantages: If you have a great selection of investment options, you can leave your assets in place and continue to invest as you have been. Leaving it in your old account also keeps your tax deferred investments in a qualified retirement account. You maintain the option of moving your funds at a later date.

Possible Disadvantages: Your investment options are limited to the options in your old plan. You will not be able to make new contributions, nor will you be able to take any loans from your old 401(k) account. You may be held liable to pay for account fees, as some companies will not cover those costs for former employees. You will also have one more investment account to maintain and balance. Keep in mind, 401(k) providers may change from time to time and it is up to you to keep track of these changes. Kiplinger has a good article about keeping track of old 401(k) plans.

Verdict: Consider this if your old plan has better investment options than your new plan. Otherwise, consider rolling your 401(k) into your new plan, or one of the other following options.

2. Roll the assets into an IRA

Your 401(k) assets are already in a tax advantaged account and rolling your 401(k) into an IRA will keep your investments growing with the same tax advantages and you will avoid the 10% early withdrawal penalty.

Possible Advantages: In addition to avoiding the 10% early withdrawal penalty and maintaining tax advantages, there are several other important benefits to rolling your 401(k) into an IRA. The biggest advantage is that you control your investment options and you are no longer limited to the investment options in your old or new 401(k) plan. This is important because you can limit your expenses and you maintain control over your accounts. Some companies change trustees and it is not your old company’s duty to notify you of any changes, it is up to you to keep track. Keep in mind that rolling your 401(k) assets into an IRA plan isn’t final - you may be able to roll it into your new 401(k) plan later. You also maintain flexibility for beneficiaries.

Possible Disadvantages: You will not be able to take loans from your IRA as you would be able to if you rolled it into your new employer’s plan. There are also several disadvantages regarding withdrawals from an IRA vs. a 401(k); in certain circumstances, 401(k) plans have a little more flexibility.

Verdict: Consider this option if you want total control over your investment, your old plan doesn’t have enough assets to keep it open, your new plan does not offer strong investment options, or you want to consolidate your investment holdings into fewer accounts.

3. Roll the assets into new employer’s 401(k) plan

This is an option I am strongly considering, but it will depend on several factors - notably my new 401(k) plan’s investment options. The other factor that I like is simplifying the number of investment accounts I need to keep track of, maintain, and balance.

Possible Advantages: Your investment maintains its tax advantages and there are no penalties to transfer or rollover your money. You will be able to borrow against your 401(k) holdings if you wish to do so, and you will minimize the number of retirement accounts you have.

Possible Disadvantages: You are limited to your new plan’s investment options. This is a biggie if your plan has limited options or higher than average expense ratios, which eat away at your returns. There may also be a waiting period before you can sign up for your new company’s 401(k) plan, which means you would have to wait to roll it over.

Verdict: Consider this option if your new plan has strong investment options and/or you want to maintain simplicity in your retirement holdings.

4. Withdraw the assets in a lump sum

Withdrawing your assets from your 401(k) plan is not something most people will recommend because you will be hit with taxes and early withdrawal penalties, which could eat up nearly a third of your total assets to that point.

Possible Advantages: Your assets (minus income taxes and early withdrawal penalties) will be available for immediate use.

Disadvantages: You will face the immediate tax impact of paying income taxes on the lump sum of the assets you withdraw (usually an immediate 20%), and you will also have to pay a 10% early withdrawal penalty if you are under age 59½. You will also lose tax deferral benefits on your funds, miss out on potential future earnings, and you will lock in any market losses that had occurred up to that point. Most importantly, you can severely reduce the amount of money you have for retirement.

You can change your mind within 60 days. Your old fund manager is required to deduct 20% for taxes when you withdraw your funds. If you change your mind and decide to roll the funds over, there is the 60-day rollover rule which allows you to roll the money into an IRA within 60 days. However, you will be required to come up with the 20% difference to reinvest the entire amount and avoid paying income taxes. You will get the 20% back when you file taxes the following year as long as you complete the rollover within 60 days.

Verdict: Consider this option only if you need the funds immediately and you cannot meet those expenses through other means. But I strongly advise you to speak with a financial planner to look at other options before doing this.

5. Transfer the assets to a qualified annuity

Transferring your 401(k) to a qualified deferred annuity is not an option many people know about, and one which fewer people take. Except in certain instances, it is not the best option.

Possible Advantages: Assets continue to be tax deferred until you receive distributions and you will not pay taxes or early withdrawal penalties to transfer your 401(k) directly to a qualified annuity. An annuity creates an income stream that you won’t outlive, instead of having a finite pool of money from which to withdraw funds (if you live a long time, you could outlive the amount of money you paid into the annuity). Your heirs may be able to inherit your annuity if you pass away during the accumulation phase.

Possible Disadvantages: Rolling a 401(k) is an irrevocable decision; once made, the decision cannot be reversed. Many annuities come with higher expense ratios than 401(k) plans or IRAs, and some states charge high tax premiums on annuity purchases. In addition, you may pass away before your annuity pays out the amount of money you would have had in your 401(k) or IRA, leaving nothing for your heirs.

Verdict: This is not for me. This is not to say annuities are bad, but there are many variables involved and I do not know enough about them to write about all their intricacies. If you think this may be for you, consider speaking with a certified financial planner or other professional for more details. Final note: beware of salesmen. Many annuities are pushed heavily because they are extremely profitable for the company that manages them.

Best options for your old 401(k)

In most cases, the best option will be to transfer your 401(k) assets to an IRA or your new 401(k) plan, or simply leave your 401(k) assets in the old plan. Your decision should be based on your particular situation.

What will I do with my 401(k)?

Actually, I haven’t decided yet. My goal for this month is to investigate my new 401(k) plan and compare it to my old company’s 401(k) plan and determine the best option for me. Personally, I think I will either roll it into my new company’s plan, or I will roll it over into an IRA. I prefer to limit the total number of accounts I have because it makes it easier to balance my portfolio and keep track of everything.

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When times are tough, making early withdrawals from your retirement funds can seem like a quick source of cash. It is. But it can be an extremely expensive source of quick cash. Many people don’t realize that making early retirement withdrawals can hit you four times at once!

Taxes

The first thing that is going to get you is the taxes. Qualified retirement plans such as IRAs and 401(k) plans (and others) have some nice tax advantages. When you make an investment into a Traditional retirement plan such as a Traditional IRA or Traditional 401(k), the money is not taxed until you withdraw it. This is designed to allow you to invest more money upfront and give you years of tax free growth. When you withdraw that money early, you lose that tax advantage and must pay the taxes immediately.

Early Distribution Penalties

Early distributions from an IRA, 401(k), 403(b) or other qualified retirement plan are subject to a 10% early withdrawal penalty. That means not only are your withdrawals taxed, but an additional 10% is taken from the withdrawal to pay the penalty. Double-whammy!

Less Money for Future Growth

Compound interest is the most important thing you have working for your retirement. The more time that compound interest works in your favor, the more money you will have when you retire. Here is a nice illustrated example of how much compound interest can work in your favor.

Possible Market Losses

If your retirement account holdings have depreciated, not only will you have to pay taxes and early distribution penalties, but you may be paying them on less money than what you originally invested. Overall, the markets have not done very well the last year or so, and it is possible that some of your investments have lost money. Leaving the money in your investments gives them time to appreciate and not only regain their previous value, but hopefully appreciate beyond your original investment.

Stay the course. If at all possible, try to avoid withdrawing your retirement funds for short term needs. There may be other ways to get the funds you need, such as working overtime, taking a part time job, or raising funds by having a yard sale or selling unneeded items on eBay.

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Invest as much as we can, while we can. The way we see it, investing as much as possible now is paramount to our future. When we have children, our income will decrease and our expense will increase. This is a recipe for disaster if you aren’t prepared. Which is why we are starting now.

March Financial Goal. My goal for March is to determine the best investment for our situation, and fully fund our Roth IRAs. There are several questions we will face before we do this. I have the answers in mind, but I haven’t shared them yet on this site. Over the next month I hope to answer these questions and share them with everyone.

Invest all at once, or use Dollar Cost Averaging?

I have read several studies that show lump sum investing is better than Dollar Cost Averaging (DCA). The premise behind this is that the market tends to go up over the long run, so the longer you have your money in the market, the longer it has to appreciate. Of course, even with lump sum investing I could invest at the wrong time. But I am not trying to time the market. I am trying to get my investment in as soon as possible and let the markets do the work for me. I can’t control the markets, so why stress over when to invest?

Maxing two IRAs is a lot of money! Are you sure you should do it all at once?

We started saving for this last year and we already have the money set aside. The maximum you can invest in a Roth IRA is $5,000 for 2008, and we are maxing out two of them at once, for a total of $10,000. It took a lot of saving over the course of last year to reach that level, but we have a good emergency fund built and we are confident we can do this without stressing our budget. Remember, we planned for this well over a year ago. We need to take advantage of this opportunity while we can because we don’t know if we will be able to do this after we have children.

Why Invest in a Roth IRA?

In my opinion, a Roth IRA is one of the best retirement options available right now. You invest with post tax money, and your withdrawals in retirement age are tax free. I recently compared Roth and Traditional IRA plans. For our situation, a Roth IRA is definitely the best option.

What about your 401(k) plan?

I am also investing in my 401(k) plan as well. My company offers a small match, of which I take full advantage. For most people, it is best to contribute up to the company match, then invest in a Roth IRA. If there are funds left over, then you should add more to your 401(k) to take advantage of the tax benefits. Again, the plan my wife and I have to to be aggressive with our retirement savings now because our financial priorities will change when we have children.

Mutual Funds, Index Funds, or Exchange Traded Funds (ETFs)?

In most cases, I’m not a fan of mutual funds. Most of them simply cannot consistently beat the market over the long term. On top of that, they generally have higher management fees and those costs are another hurdle to beating the market.

For investing, I prefer efficiency, and that means minimizing fees and other costs. The best way I know how to do that is to match the market by investing with index funds. Index funds are dirt cheap to run and generally have the lowest fees possible.

Exchange Traded Funds are similar to index funds, but they are traded on the open market like a stock. They sometimes have lower fees overall, but usually come attached with brokerage or transaction fees. The benefit for investing with ETF’s is usually a cheaper set of ongoing costs. ETF’s are also usually better for large lump sum investing vs. dollar cost averaging because of the brokerage fees.

For my wife and I, we will be looking into various index funds and their associated ETF’s.

What type of fund will you buy?

I don’t know. I need to rebalance our portfolio, and will buy into funds or sectors to even everything out. I don’t generally sell my funds, I usually just allocate new funds toward the areas that need propping up. Over the course of the next few weeks my wife and I will discuss our current portfolio and our long term goals. Our investment decisions will be based on those discussions.

Will you share the outcome?

I’ll try to share my thought process and the fundamentals behind my decisions, but I may not tell you the exact fund because I don’t want influence anyone regarding a specific fund. However, fundamentals are fundamentals and people can use that information to make their investment decisions based on their situation.

Tips, ideas, suggestions? If any of you have tips and/or ideas, I am open to suggestions. Just leave a comment; I always keep an open mind regarding investments.

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At that point, I wasn’t earning enough money to fully max out my IRA and contribute to the TSP. I had to decide which investment plan was the best for me. Since I didn’t receive a “company” match to my TSP, I chose to invest in a Roth IRA. (Why choose Roth over Traditional?)

In my current situation, I have a 401(k) plan with my employer, and I have the option of investing in an IRA plan as well. I face the same question a lot of people face: where should I invest my retirement funds - in a company 401(k) plan, or in an IRA?

Company 401(k) Plan: Company 401k plans are similar to Traditional IRAs as far as taxes go - contributions are invested before taxes are withdrawn, which can lower your adjusted gross income (AGI), giving you a tax break now. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal. There is also the possibility of investing in a Roth 401(k), although not all employers offer this option. The maximum annual contribution amount is the same as a 401k and is set at $15,500 for 2008.

A distinct benefit in favor of 401(k) plans is a possible company match, which is essentially free money for employees. My current company offers a 401(k) match of up to 1.5% of my pay. It isn’t very much, but it is free money and I take advantage of every penny of it!

IRA: There are two main types of Individual Retirement Accounts: Traditional and Roth. (I have chosen not to focus on SEP IRAs, SIMPLE IRAs, or other forms of IRAs as they are not applicable to everyone).

• Traditional IRA: The main benefit of a Traditional IRA is that the money can be fully or partially deductible, depending on your situation. The money is invested before taxes are withdrawn, which can lower your AGI, resulting in an immediate tax break. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal (barring certain exceptions).
• Roth IRA: Roth IRAs are non-deductible, which means you use post-tax money to fund your account. However, the distributions made during retirement age are tax exempt, which is the main reason people invest in a Roth IRA. As with the Traditional IRA, early withdrawals may incur stiff penalties.
• For both IRAs: These are individual investments, meaning there are no company matches. There may be certain tax or eligibilty restrictions for Traditional or Roth IRAs based on your income, filing, and marital status. The investment limit for 2008 is $5000.

Pros and Cons of 401(k) Plans and IRAs

401(k): The biggest benefit of a company 401(k) plan is the possibility of having a company match. Free money is something you shouldn’t pass up, especially when it will compound over time. On the downside, some company 401(k) plans may have a limited selection of funds to choose from. Your investment options will be limited to whichever funds are in the company plan, which can be detrimental if your plan consists primarily of funds with high expenses.

IRA: With IRAs, all investment responsibility lies with the individual. He or she must decide where to invest, how much to invest, etc. This can be overwhelming for some people, but there is always the option of paying someone to manage your funds. The benefit of controlling your investment is the flexibility of deciding where to invest: funds, stocks, bonds, ETFs, etc. the possibilities are limitless. The other benefits of IRAs include controlling your tax diversification options by investing in a Roth IRA for tax free withdrawals, or investing in a Traditional IRA to lower your AGI and current tax obligations.

Where Should You Invest?

Only one of these types of retirement plans involves the possibility of free money - the company 401(k) plan. If your company offers a match, it is probably in your best interest to invest in a 401(k) plan at least to the point of receiving the maximum company match. It is hard to pass up free money!

After you have put in enough money to get the match, I would consider investing in a Roth IRA because you will be able to withdraw this money tax free in retirement. Doing this diversifies your future tax liabilities by having a taxable and non-taxable retirement funds.

If you have enough money to invest for the full company match, and max your Roth IRA, then you should consider investing more money in your 401(k) plan. This will ensure you maximize your retirement contributions, and diversify your tax obligations both now and in retirement.

Always Research Your Investment Options Before Investing!

These are only my recommendations based on common situations. You should always ensure your investment decisions are based on your needs and the amount of risk you are willing to take. The most important thing is to get started and keep investing. Your future is worth it!

By, the way… for those who are curious, I max out my Roth IRA, and invest in my 401(k) plan above the amount of my company match. My goal is to funnel as much money as possible into my retirement accounts while I am young and able to do so!

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Traditional IRA

Simplified Definition: A Traditional IRA is a tax deferred retirement vehicle. Contributions to a Traditional IRA plan may be tax deductible depending on the taxpayer’s income, tax filing status and other factors. Contributions to Traditional IRAs are made on a pre-tax basis, meaning the money is invested before it is taxed.

The benefit to investing pre-tax money is that it has the potential to lower your current tax bracket, and your money can grow tax free until you withdraw it. Qualified withdrawals are treated as ordinary income and may be subjected to income tax.  

Income limits: Everyone is eligible to contribute to a Traditional IRA, but not everyone will get the benefit of a tax deduction. Here is a list of the Traditional IRA deductibility limits.

Withdrawals: Traditional IRA holders are eligible to withdraw from their IRA at age 59 ½, at which point their withdrawals are taxed as ordinary income. There are stiff penalties for early withdrawal (with certain exceptions).

Required Minimum Distributions: Owners of Traditional IRAs are subjected to Required Minimum Distributions, which begin at age 70 ½. This means Traditional IRA holders are required to make a minimum withdrawal every year regardless of whether or not they need the money.

Advantages of a Traditional IRA: There are several advantages for investing in a Traditional IRA, and they primarily deal with taxes. The tax savings at the time of investment may be enough to decrease your taxable income to a lower tax bracket. Many retiree’s income is lower in retirement years, thus they may have a lower tax rate when they withdraw their funds. Depending on your income, you may be able to use a Traditional IRA to lower your tax bracket during your working years, and then withdraw your money in retirement in a low tax bracket.

Disadvantages of a Traditional IRA: The minimum required distribution is a disadvantage because it requires IRA holders to withdraw a certain portion of their funds - whether they want to or not. It is also difficult to determine what your tax rate will be in retirement.

Roth IRA

Simplified Definition: A Roth IRA is a tax exempt retirement vehicle. Contributions to Roth IRAs are not tax deductible when they are made; however, qualified distributions made during retirement years are tax free.

Income limits: A person filing their taxes as single cannot earn over $95,000. Married couples are limited to an annual maximum income level of $150,000.

Withdrawals: The minimum withdrawal age is 59 ½. When the money is withdrawn, none of it is taxed. The principle can also be withdrawn at any time without penalty, however, the earnings must remain in the IRA or they will be subject to taxes and penalties if withdrawn early.

Required Minimum Distributions: There is no minimum distribution for Roth IRA accounts.

Advantages of a Roth IRA: The biggest advantage of a Roth IRA is tax free withdrawals on the principle and all earnings. The other advantage is the absence of minimum withdrawal requirements.

Disadvantages of a Roth IRA: Not everyone qualifies for a Roth IRA because of the income limits.

Which IRA is Better - Traditional or Roth?

Investing with IRAs is a great way to diversify your taxes in retirement years, and as you can see, there are distinct advantages to each type of IRA. If you are like me and have the option of funding a company 401(k) plan or other tax deferred retirement plan, then a Roth IRA may be the way to go. This gives me investments that benefit me now by decreasing my taxable income with my 401(k) contributions, but also investing in a Roth IRA, which will give me tax free withdrawals in retirement. It is very difficult (or impossible) to predict our future tax brackets, so tax diversification is a strong benefit to retirement planning.

I recommend investigating your personal situation and investing in whichever plan you decide is best for you. If you are eligible for both, you also have the option of splitting your investment to take advantage of tax benefits now, and in retirement.

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Just a reminder – the maximum you can invest in a Traditional or Roth IRA for 2007 is $4,000 or $5,000 if you are eligible for catch-ups (age 50 and older). The rates increased to $5,000 for 2008, and the maximum amount with catch-up contributions is $6,000.

Recent IRA contribution limits:

Calendar Year	Max Contribution	Catch-up Contribution, Age 50+	Max Contribution, with Catch-up
2002-04	$3,000/year	$500/year	$3,500
2005	$4,000/year	$500/year	$4,500
2006-07	$4,000/year	$1,000/year	$5,000
2008	$5,000/year	$1,000/year	$6,000

In my opinion, the IRA is an investment vehicle everyone should take advantage of if they are eligible and if they can afford it. The tax deferment benefits are a great way for your investment to grow without the drag of taxes slowing it down. 

It is important to invest in IRAs and max them out if possible because you only get one chance to do it. Once the eligible dates for 2007 have closed out, you can no longer invest you money in an IRA for that year.

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From 9 a.m. to 6 p.m. eastern time, this Friday (Jan 25th, 2008) these fee-only planners will take questions - free of charge! These planners are well versed in the subjects of investments, taxes, insurance, estate planning, and saving for college and retirement.

The NAPFA planners will answer as many questions as time permits, and based on their run last week, they answered a lot of questions - over 150 e-mail questions, and an untold number over the phone lines. Here is a link to last week’s transcript of the live discussion held on Tuesday, January 15.

You can send the planners an e-mail question anytime between now and the day of the discussion. On the day of, you can call 1-888-919-2345 between 9 a.m. to 6 p.m. eastern time, and a NAPFA adviser will respond to your question.

Normally, these fee-only planners charge clients $100 to $250 an hour. So take advantage of this great deal - you don’t even have to pay for the phone call!

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About Louis Navellier: Navellier is one of the most well-respected and successful growth investors of in recent history and this book is a reflection of what he does best – it gives readers a understanding of how to increase wealth by using the same growth investing strategies Navellier employs.

About The Little Book That Makes You Rich: I think this book is very straightforward and well written. The book simplifies selecting growth stocks down to 8 simplified criteria, and gives them to you right up front. Translation - the book isn’t trying to sell anything extra or make you work to find the answers. They are there, you just need to read and apply them.

The 8 selection criteria are:

1. Positive earnings revisions
2. Positive earnings surprises
3. Increasing sales growth
4. Expanding operating margin
5. Strong cash flow
6. Earnings growth
7. Positive earnings momentum
8. High return on equity

One of the most important investment principles in this book is Navellier’s belief that one shouldn’t allow human emotions to become involved in investment decisions. You should not fall in love with stocks or believe “hot stock market tips” you hear from an acquaintance - or anyone else for that matter.

Will this book make you rich? No. No book will make you rich! But I think that after examining Navellier’s track record and reading these investment principles, there is opportunity here. As with every other investment decision, do your research and make your own decisions based on what you think is the right thing to do.

Buy or Don’t Buy: If you plan on buying individual growth stocks, I think this book can be a beneficial addition to your investment library, and at $13, it is a great investment! (pun intended). 

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I thought long and hard about the situation, and I finally decided the best action was to roll my IRA out of the investment I was in. Though I was originally told the $1,000 was to be spread out over the course of my investment plan, the $1,000 was really an up front fee to the broker. The loss of the $1,000 hurt, but when I analyzed the numbers, I realized that paying lower fees would allow me to keep more of my money working for me and compounding for a long period of time. In the end, the numbers don’t lie - having the lower fees would give me a better long term return. I counted the $1,000 as a sunk cost and vowed to do better research before ever investing again.

In the end, I am not mad at my mistake of “losing” $1,000. I got into the habit of automatic investing, which is something I continue to do and will continue to do in the future. More importantly, I learned that I need to educate myself and learn how to make my own investment decisions. This is a large reason why I started this personal finance blog - to learn and share information about personal finance. If one person reads this and doesn’t make the mistake I made, then I’ve accomplished something good.

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Do you have an investment story to share? Feel free to leave a comment, or visit the personal finance blog, Moolanomy, which is currently holding a book giveaway for people willing to share their financial story (be sure to read the rules!).

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