Q: My late sister left most of her estate to my daughter, who's in her third year at a pricey college, with the belief that she'd use the money for tuition. But my child is already funding her education with grants and loans, and I'd rather she not spend her entire inheritance right now. How can we maximize the value of this gift?
A: Mom, I'm hard-pressed to think of a better use for your sister's gracious gift than making sure your daughter will enter adulthood free of student loans. Using her inheritance to pay tuition is a sound financial move in today's world of low returns. If your child has federal Stafford loans, their fixed interest rate is 6.8 percent. Think of the cash she'd save if she could avoid paying that interest—it would be like earning money risk-free at a rate of almost 7 percent. These days, no safe investment (say, a federally insured certificate of deposit) provides such a high guaranteed return.
Without the burden of monthly loan repayments, your daughter will be able to make contributions to a retirement fund, like a Roth IRA or 401(k), as soon as she starts her career. By using her money to safeguard her financial future, she'll benefit from your sister's gift for the rest of her life.
Q. I'm a 20-year-old soon-to-be college student, and I have $5,000 to put toward savings or other investments. I plan to add $100 to my account every month until I retire. What financial tool would provide the best immediate return while allowing me to spend any earnings I accrue during school?
A: Time for a precollege class on money, my dear. You can't expect to use the same account for saving and investing. Those goals require contrasting approaches, neither of which should involve aiming for quick returns.
With interest rates on savings accounts stuck at 1 percent or lower, there's really no return to be had other than the satisfaction of knowing your stash could keep you from going into credit card debt, taking out a payday loan, or borrowing from friends should you need extra funds. A savings safety net is a smart—but not a moneymaking—move.
When you invest in order to fund a long-term goal like retirement, on the other hand, you should aim to make a significant return and compound your earnings. Let's say you use your $5,000 to fund a diversified portfolio of stocks and bonds that should yield, on average, an annualized 6 percent return. If you continue to invest $100 every month and allow your earnings to grow, you could have about $452,000 in 50 years. (Keep that money in a Roth IRA and your withdrawals will be 100 percent tax-free.) If you make monthly deposits but spend what you earn, you'll wind up with just $65,000.
I recommend that you split your monthly $100 contribution, earmarking $50 each for savings and your investment portfolio. (Once you've set aside the equivalent of eight months' worth of living costs, feel free to invest the entire sum.) And if you want extra cash to spend during college, find a part-time job. That financial plan gets an A-plus.
Q. My husband and I are both 32, and we have three children under 7. Aside from a $2,500 credit card balance, we are debt-free, having recently paid off our house with an inheritance. With the money we used to use for our monthly mortgage payment, we've been saving for retirement and our children's education. But my husband has $75,000 in graduate school loans coming due soon, and I think we should repay them instead of contributing to the kids' college funds. He doesn't agree. What do you think?
A. The short answer is that you are right. Deal with his debts and focus on your retirement savings before you worry about sending your children to school. Here's what else you should do: Take out a new ten-year, $75,000 mortgage and use it to rid yourselves of his loan.
Let's assume your husband has Federal Stafford Loans that charge 6.8 percent interest. In order to repay $75,000 on a ten-year schedule, you'd owe about $860 a month. But if you took out a mortgage for the same amount and time period and put the proceeds toward his debt instead, your monthly payment would be approximately $720. I'd also like you to buy a ten-year, $75,000 term life insurance policy on your hubby (so that the mortgage will be taken care of in the event of his death), which should cost about $15 a month if he's in good health. And there you have it: You've polished off his school debt and saved a ton in interest. (Compare $11,490 for mortgage interest with $28,572 for the student loan.) This strategy could offer even bigger savings if your husband has private loans, which typically charge higher interest rates.
If your husband wants to continue saving for your kids' education as well, you'll need to have a frank chat about your finances. On my Web site SuzeOrman.com, under Suze Tools, you'll find a free expense tracker that can help you identify potential opportunities for savings—money you could set aside for a college fund.
Q: My employer recently began offering a Roth 401(k) plan and matching contributions up to 2 percent. I already have a Roth IRA worth $5,000. Should I invest through my company as well?
A: You should definitely contribute to your employer plan, and I think the Roth 401(k) is a great way to go. During retirement, you'll be able to make tax-free withdrawals from both your Roth IRA and your Roth 401(k). (Distributions from traditional IRAs and 401(k) plans are subject to ordinary income taxes.) You can't afford to pass up free cash, which is what you're getting when an employer contributes to your 401(k). Set aside money only up to the point of the company match—in this case, 2 percent of your salary. (You can contribute up to $17,500 per tax year; that amount increases to $23,000 if you're at least 50 years old.) If you can afford to invest more than that, I'd advise you to switch your focus back to your IRA. (The yearly contribution limit is $5,500; if you're at least 50, it's $6,500.) You can't access deposits you have made to a Roth 401(k) without penalty unless you have had your account for five years and you're at least 59½. With no such restrictions, a Roth IRA provides a better, more versatile option if you need to withdraw contributions pre-retirement.
Q: I'm in my early 60s and earn $2,000 a month from part-time work and Social Security. I rent my home, own my car, and have no debt, but I have just $3,000 in savings. I'd like to begin making monthly contributions of $250 to catch up on my retirement funds. Should I buy an annuity, a Roth IRA, or a regular IRA?
A: While it's never too soon to plan for retirement, a late start is better than none. At this point, a Roth IRA will give you the most flexibility: You can always withdraw money you contribute without penalty or tax.
Let's assume your Roth IRA earns 4 percent a year. (People in their 60s should keep no more than 40 percent of their long-term investments in stocks to limit their exposure to market risk.) If you contribute $250 a month, you could save approximately $37,000 in just ten years. In your situation, that would be a great achievement. To ensure that money could help support you for the rest of your life, plan to withdraw no more than 5 percent a year. (That works out to $1,850 in the first year you're fully retired.)
I think it's great to focus on setting money aside, but there's an even better way to prepare for retirement: Reduce your expenses. If you live in a pricey area, consider moving to a smaller home (as long as relocation costs don't exceed any potential savings on rent or utilities) or perhaps getting a roommate. Sharing your space can not only improve your financial situation but also—if you find a great roomie—provide an emotional boost.
In addition, you may want to suspend your Social Security benefits and restart them when you're older. (You're allowed this one-time mulligan only if you began taking benefits within the past year.) Since you're younger than 66, which I presume is your full retirement age, you're collecting less than 100 percent of the benefit you're entitled to. While you would have to repay money you've already received, in less than four years your benefits could grow by 25 percent. You can't earn a return that high on another investment without taking on a lot of risk.
Q. I am a 45-year-old single woman with no children. I make $155,000 a year, have $165,000 in savings and $125,000 in a 401(k), and owe nothing other than my mortgage (14 years left on a $240,000 loan at 3.5 percent). What's the best way to make my dream of retiring in ten years come true?
A. My advice is to modify your dream right now. You simply don't have enough set aside in retirement savings to stop working as soon as you'd like. Let's say the $125,000 that you have in your 401(k) grows at an annualized 6 percent rate and you manage to add $15,000 a year to it—that's just 10 percent of your salary—you could save about $430,000 over the next decade. I know that sounds like a lot, but those funds might have to last you for at least 30 years. And that's not because I'm suggesting you're going to be an old-age outlier; the average life expectancy for a 55-year-old woman today is 83.
In the first year of retirement, you should plan to withdraw no more than 4 percent of your total funds. (You can adjust that sum for inflation in subsequent years, but even that rate is pretty aggressive for someone planning to retire at such a young age.) Four percent of $430,000 is $17,200. But because a withdrawal from a traditional 401(k) is taxed as ordinary income, you might net $13,000. That's less than $1,100 a month, and I doubt that's enough for you to live on, even if you're frugal. So let's say we shift half your current savings into investments on the assumption that $82,500 is an adequate amount for your emergency fund; that's still not enough money for you to retire comfortably. I know you don't like hearing that you'll need to work until 67 or 70, but better to hear it now than to realize you've made a big mistake later.
If you save diligently over the next 17 years and withdrawing 4 percent a year (adjusted annually for inflation) generates enough cash for you, you may be able to retire early—at age 62. (Use the free retirement income calculator at TrowePrice.com/RIC to analyze your options.) Even though you will be eligible for Social Security at that time, think seriously about delaying your benefits until at least 67, when your payout could be 30 percent higher. Consider working part-time—or better yet, full-time—for a few years to supplement your income until the checks arrive.
Q: I'm a 46-year-old single woman earning $34,000 a year. Sometimes I feel so anxious about having enough to retire on that it takes away from my enjoyment of life. I have $30,000 in mutual funds and IRAs (but no pension), and no debt apart from my mortgage, which will be paid off in about eight years. I've been unemployed twice due to layoffs, so I'd like to have access to my money. Assuming I can work for quite some time, roughly how much do I need to save? I live simply but don't want to end up eating cat food.
A: While I understand your concern, I have to say that you're doing an impressive job considering your relatively modest salary. Many women making twice as much as you are saddled with debt and a huge mortgage they'll be paying down well into retirement. Give yourself credit for being so good with your money.
The best news here is that you'll finish off your mortgage in your early 50s. That means you don't need to save nearly as much as someone who anticipates having to keep making mortgage payments after she stops working.
Once you pay off the house, I want you to keep making monthly payments—to yourself. Invest that same amount in a Roth IRA. If you follow a few simple rules, you'll be able to withdraw all the money in retirement without paying a penny of tax. When you reach the annual maximum contribution for the Roth, build up an emergency cash reserve. The more you put away, the better.
Because you've been so house smart, once you turn 62 you will be eligible for a reverse mortgage: If you find your own retirement savings aren't enough, a reverse mortgage allows a lender to pay you income (in a lump sum, a monthly advance, a line of credit, or a combination of all three) based on the value of your home. There's no risk of losing the property. I hope that hearing all this will help you enjoy your life more fully today.
Q: I am a 24-year-old mother of two, and I'm getting a divorce. My salary is about $50,000 a year, and I receive no child support. I plan to return to school and will probably make only about $20,000 once I cut back my work hours. I now put 6 percent of my income into my 401(k), adding a percentage point per year. Should I keep putting money into my 401(k), despite my limited income? Or should I wait until I finish school?
A: I wish I could bottle up your spirit and share it with the world. After reading your first three sentences, I was sure you would ask how you could make it as a single parent on one income that is dropping 60 percent. But instead you're focused on building security. That tenacity tells me you can do anything you set your mind to.
But you need to be realistic. On $20,000 a year, you will already be stretched thin. So please don't shortchange basic needs to keep saving for retirement while you are in school. Look at school as a big part of your financial plan: By upgrading your skills, you give a boost to your future earning power. When you're back working full-time, you can refocus on retirement investing.
But if you seriously think you can save for retirement and support your family while you're in school, here's my strategy: As long as you have a large emergency savings fund that can cover eight months of living expenses, keep investing in a 401(k) if you get a company match. Maybe it can't be 6 percent of your salary next year (that would be $1,200 of $20,000), but even at half that, you would benefit from the company match.
If you don't have an emergency savings fund, or your employer doesn't offer a matching contribution, skip the 401(k) while in school and invest in a Roth IRA . It has no tax or penalty if you dip into your contributions to cover an emergency. Only your Roth earnings would be hit with a tax, plus a 10 percent penalty for an early withdrawal. So your Roth could do double duty: When things go well, it serves as a retirement account; in times of trouble, you can pull out your Roth contributions without tax or penalty. Any money you invest in a Roth should go into low-risk investments, such as a money market fund, CDs, or short-term Treasury bills. Once you're out of school, you can move your investments to stock exchange-traded funds or mutual funds; over the long term, stocks will help you earn inflation-beating gains. Over the short term, they are too volatile to use for a quasi-emergency fund. Good luck!
Q: I'm in my early 30s and have been living with my 45-year-old boyfriend for almost a decade. We own a house and have joint and individual checking accounts, Roth IRAs, a will, and power of attorney documents—everything you recommend. My concern is that my boyfriend isn't saving enough for retirement. At my urging, he started a Roth IRA but has invested less than $5,000 in it. He is anticipating a $150,000 inheritance from a relative to see him through retirement, which I don't think will be enough. I'm worried that I'll end up supporting us both.
A: Your boyfriend is being irresponsible. Anticipating an inheritance and receiving one are two different matters. Given that so many of us are living longer, combined with an increased need for care as we get older, the reality is that the money family members intend to bequeath can end up going toward their own living costs. If your boyfriend does eventually receive the inheritance, it could come when he's well into his 60s—is he prepared to wait that long? Even then, $150,000 isn't a windfall he can rely on to cover all of his retirement costs. To live off of the money, he will want to invest it conservatively in bonds to generate income and avoid eating away at the principal. I'm going to be generous and assume he'll earn 5 percent interest annually in a municipal bond (which is exempt from federal and often state income tax). At that rate, his $150,000 would generate about $625 a month. I bet that's not enough to pay for his living costs as well as all the expenses that come with enjoying one's later years (travel, going out more often, etc.).
Your partner needs to grow up rather than hope his rich relatives and conscientious girlfriend will bail him out. I get the sense that the good financial choices you've made together are the result of your planning and initiative, not his. It's okay for one person to be the leader, but both of you have to take responsibility. If he isn't up for that, you need to rethink the relationship—and all the money you put into it.
When he's ready to get serious about saving, I want your boyfriend to turbocharge his Roth IRA. The annual maximum contribution is $5,000 if you are under 50 years old and earn less than $101,000 ($159,000 for married couples); it's $6,000 a year if you're 50 or older. Pleas factcheck maximum contributions for 2012 since they change every year And tell him I said he'd better be taking advantage of any retirement accounts offered through his job, such as a 401(k). Many employers will match your contribution if you agree to have money deducted from your paycheck and invested in the account. That match is like a bonus; don't turn it down. Because your partner is getting a late start, he should put money in a regular taxable investment account and choose low-cost index funds or exchange-traded funds. Today's tough economic climate makes it more important than ever to minimize the fees you pay on your financial accounts.
Q: I have two daughters in junior high school, and not a penny saved for their college educations. How can I play catch-up quickly?
A: Even if you're starting late, the important thing is to start—but you need to take the time to plan the right way to save. Desperation can lead to rushed, unsafe investments, and the worst thing you could do for your daughters would be to put your money at risk in an attempt, as you say, to play catch-up. The expenses of college are daunting, and for many parents—especially those with more than one child—the thinking is, 'I'll never manage.' You need to get out of that mindset, because saving for college can begin with a few very simple actions.
Since you know you'll need to begin spending your savings in four to five years, be conservative. Keep your money in high-yield money market funds (you can find the ones paying the best interest rates at www.ibcdata.com), treasury notes, certificates of deposit and series EE bonds. The steps to open these accounts are quick and simple and can be completed right at your local bank, but you need to start very soon. You should also remember that as the cost of higher education increases, both the government and colleges are beginning to offer more financial aid in the form of grants, loans and work-study programs. More than half of all undergraduate students are awarded some form of financial aid, so the odds are you won't have to shoulder the financial burden on your own. The most important thing, though, is for your daughters to see you taking responsibility for your money. True education starts with messages that are passed down.
Protecting What You Save
Q: I'm a 38-year-old single mother of three young children, and I'm considering moving in with my boyfriend, who's older and living on a fixed income. I want to split our expenses evenly, but he'd like me to pay more to cover my kids. (His are grown.) He'll handle the bills because I'm bad with money. Am I obligated to give him additional funds?
A: Nothing brings my blood to a boil faster than a capable woman telling me she leaves money matters to her man. Your first challenge, my dear, is to take on your role as an equal partner in the management of your soon-to-be-blended finances.
I always advise cohabiting couples to add up their monthly expenses, then split them according to each person's monetary contribution to the household. Let's say you bring in 60 percent of the family's combined income—you're responsible for 60 percent of the bills. If your boyfriend wants you to fork over more than your share, you need to have a serious talk with him before you pack a moving box. He's in a different stage of life; he's already raised his children. If he doesn't want to support yours, this conflict isn't about splitting finances. It's about determining whether he's ready for the responsibility that comes with a young family.
Q: In the past four years, I've paid off all my debts and saved enough for a six-month emergency fund. Should I invest some of it in the stock market? If so, what percentage? I've never had this much cash sitting in the bank before, and I don't know if it's doing what it should.
A: Paying off debt and building a six-month backup fund is a major accomplishment—good for you! (And keep it up.)
While it's fantastic that you want to make the most of this money, you should definitely not invest it in the stock market. This is your emergency savings—so you need to know it's going to be there for you the next time one inevitably arises. You just can't count on the market in the short term: Say you had $20,000 in emergency savings on January 1, 2008, and you put that money into a stock market index fund. Then, on December 31, 2008, you were laid off. You might have told yourself you'd be okay with your severance and your savings. But when you checked your account, you'd have found that its value had fallen to $12,600, since the S&P 500 stock index fund was down 37 percent.
The key with emergency savings is safety first. And second. And third.
Q: I gave a friend my life savings to put away for me. She has since been laid off and is going through some financial trouble. She has called several people asking to borrow money. I'm afraid she has tapped into my funds. How do I ask for my money back without telling her I know about her financial problems or jeopardizing our friendship?
A: The real question is, why did you give your life savings to someone else to manage? Were you trying to avoid dealing with it? If so, you have just learned one of the most important money lessons: You, and only you, should control what happens to your money. With your financial future on the line, it makes absolutely no sense to push responsibility onto somebody else. You need to find your power and take control of your life.
Even if your friend is a professional whom you hired to help manage your money, that does not mean your finances should be out of sight, out of mind. At the very least you should be receiving a quarterly statement from a legitimate third-party bank, brokerage, or mutual fund where your money is invested. Your panic tells me that hasn't been happening.
You have put your life savings at risk simply because you don't want to hurt your friend's feelings. It is time to summon the courage to be responsible for yourself and your money. There need not be any accusation or apology in your talk with your friend. Simply say you appreciate her willingness to help, but you have turned over a new leaf and are now taking responsibility for your own finances. The fact that your friend was laid off and may be in financial trouble is irrelevant. This is about you gaining control of your future—control you never should have handed off in the first place.