All about the Roth IRA – your key to tax-free retirement!

If you’ve read my primer on retirement, you should have a good idea of the benefits of investing in a Roth IRA. If you haven’t read it, let me give you a quick rundown before we get into the gritty details:

Meet the Roth IRA

Unlike a Traditional IRA (“Individual Retirement Account”), with a Roth IRA you have to pay taxes on the income that you invest. (The money you put into a Roth IRA is called a “contribution.”) However, instead of that money (plus all the growth) being taxed when you take it out at retirement (after age 59 1/2), with a Roth IRA you get to make the withdrawal tax-free (The money that you take out of a Roth is called a “distribution.”)

Also, like a Traditional IRA or 401k, all the growth and reinvested dividends in a Roth IRA grow tax-free while they remain in the Roth account.

That’s the Roth IRA in a nutshell. Now let’s look at some of the details below that might also sway your decision on where to put your retirement money. (And for a complete look at those details, you can check out IRS publication 590. I’ll warn you though, it’s as dry as the name suggests.)

The Roth IRA has “rules and $#%&” too…

Contributions

In order to contribute money to a Roth IRA, you must have “earned income” that amounts to at least as much you’re going to invest. Thus, if you want to put in $2500 into your Roth IRA in 2010, you must’ve received at least that amount of earned income in the same year. This then begs the question, “what the heck counts as earned income?”

Earned income (or “compensation”) is defined as wages, salaries, tips or professional fees. Essentially, it’s what shows up on your W-2 as “wages, salary, tips” etc. This does NOT include money from investments like interest, dividends, or capital gains. Also NOT included as compensation are payments from social security, disability, pensions, annuities or income from property.

The most you can contribute in one year to a Roth IRA is $5,000 for 2010 (that is, if you ONLY contribute to a Roth IRA for retirement.) This amount will be adjusted in $500 increments, when required, to keep pace with inflation. There is one exception to this maximum IRS limit: if you’re 50 years old or older prior to 2011, you can contribute an additional “catch up” amount of $1,000 to your Roth IRA, for a grand total of $6,000 in 2010.

In 2010, in order to contribute to a Roth IRA, you also must have an Adjusted Gross Income (AGI) of less than $121,000 if you’re filing single ($177,000 for those married filing jointly.)  Also, the amount you can contribute to a Roth IRA is “phased out” for those filing single whose AGI is between $106,000 ($167,000 if filing jointly) and $121,000 ($177,000 filing jointly.)

One nice thing about the contributions to a Roth IRA is that for a given year (say, 2010), you have until the tax deadline in the following year to make contributions. Therefore, for most people, April 15th 2011 would be the last day you could make Roth IRA contributions for 2010.

(Special note on employer-matching contributions for Roth 401ks: Employer-sponsored Roth 401ks are similar in their tax treatment to Roth IRAs (and similar in their contribution limits to ‘regular’ 401ks, which are pre-tax.  One important difference is that employer matching contributions are ALWAYS pre-tax, and will go into regular 401k accounts, even if your own contributions are sent to a Roth 401k.)

Distributions

If the idea of receiving tax-free income in your golden years isn’t enough, the Roth IRA also has some other benefits when it comes to receiving distributions.  These benefits give you some flexibility and liquidity that is usually reserved for taxable accounts.

Distribution of your regular contributions – You can take out the amount you’ve contributed to a Roth IRA tax- & penalty-free at anytime (I recommend only doing this if you really have to; chant the mantra: “Retirement savings are for retirement!”) For example, let’s say you’ve contributed $5000 per year for 4 years to your Roth IRA. Then, at age 42, you lose your job and need to tap your IRA in this emergency situation. You could take up to $20,000 worth of distributions from your Roth IRA without penalty tax-free, since you made an equal amount of contributions over the years.

Qualified Distributions – With a Traditional IRA, you can generally only take the money out without penalty if you’re over 59 1/2, and then you still have to pay normal income tax on that money. With a Roth IRA, some of the ways in which you can take out money tax and penalty-free are known as “qualified distributions.”

“A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

  1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
  2. The payment or distribution is:
    1. Made on or after the date you reach age 59½,
    2. Made because you are disabled,
    3. Made to a beneficiary or to your estate after your death, or
    4. One that meets the requirements listed under First home under Exceptions in chapter 1 [of IRS publication 590] (up to a $10,000 lifetime limit).”

If you receive a distribution that is not a qualified distribution, you may have to pay the 10% additional tax on early distributions.

Item D means that if you’re a first-time home-buyer, you can take a distribution of up to $10,000 in earnings (after using all the contributions) for the purchase of this home (as part of a down-payment, for example.) If your spouse has a Roth IRA and is also a first-time home-buyer, she could use $10,000 of her Roth IRA in the home purchase as well (for a total of $20,000 between the two of you.) Note that you can also use your Roth IRA distributions in the same way for a child, grandchild, parent or other ancestor that is a first-time home-buyer.

Additionally, should you kick the bucket early, your beneficiaries can use your Roth IRA distributions tax-free. This makes a nice life insurance bonus out of the Roth IRA (for your sake, a benefit that hopefully won’t be used!)

You can also use Roth IRA distributions penalty-free (but not tax-free) for up to the amount required to pay for your qualified higher-education expenses (as long as you paid for those expenses with savings, loans, wages, a gift or an inheritance, and NOT through a tax-free scholarship or grant.)  Even though your Roth earnings withdrawals are not tax-free for qualified higher education expenses, you may be able to used tuition deductions or education credits to offset the taxes from that income.  (However, there are much better ways to save for eduction.)

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

This means that if you want to start a retirement fund but think that in several years you might decide to buy a house (for the first time) or go back to school, a Roth IRA may be a good place for your money in any event.  However, I would caution that if your plan is to use a Roth IRA to fund something other than your retirement, you can’t really count that Roth IRA money as part of your future retirement.

As stated in my article on retirement, I believe that funds set aside for retirement should ONLY be used for that purpose. So, make sure you keep your “true” retirement money separated (at least in your mind) from your “maybe-for-school-or-a-house, maybe-for-retirement” money.

Conversion – You can also convert a Traditional IRA or 401k/403b into a Roth IRA. Keep in mind that you’ll have to pay the taxes in the current year at ordinary income rates on the basis amount of Traditional IRA that you’re converting.  So, if you’re in the 25% tax bracket and convert a $100K Traditional IRA to a Roth, you’ll pay $25K in taxes that year.  (For 2010 conversions ONLY, you have the option of spreading the $100K of income equally over 2011 and 2012.)

Avoid the 10% penalty on withdrawals of Roth funds from converted IRAs

One important exception to the general rule of being allowed to take contributions out of Roth IRAs at any time tax & penalty-free is converted IRAs.  If you convert a Traditional IRA/401k to a Roth IRA, you cannot take out any money within the 5 tax-year period starting with the year that the conversion was made unless you want to pay the 10% penalty (bad idea.)  So, if you convert in tax year 2010, you can’t withdraw those rollover contributions until January 1st, 2015.

Ready, set, Roth!

Now you should have a deeper understanding of the Roth IRA, a powerful retirement vehicle that could save you a bundle in taxes after you retire. If you combine the over-59 1/2 tax-free distributions with the additional distribution flexibility of funding your first home purchase or higher-education costs with your Roth, this IRA might be the right investment vehicle for you.

(To find out why the Roth IRA may NOT be the best retirement vehicle for you, read this.)

Advertisements

What You Need to Know About Retirement NOW (Don’t wait until it’s too late!)

How do you wanna retire? On a beach in Tahiti sipping a Mai Tai? Pursuing your dream of becoming a world class sky diver? Maybe quitting the rat race early at age 45 and telling the world to go @#^& itself?

However you envision your retirement, if you want to make those dreams come true, you need to start planning and taking action NOW! Otherwise, you might find yourself filling grocery bags at the local Slaveway well into your eighties. I don’t mean to scare you, but you can’t count on anyone else to provide for your dotage besides yourself. Not your kids, not your girlfriend, and certainly not your employer or the government (although the last two will certainly help you help yourself as you’ll see below.)

First things first

Before we get into retirement saving, you gotta settle your financial house. For that, I got rules!

Pay off any double-digit interest rate debt (read: credit cards), make sure you’re properly insured and have a short-term reserve for emergencies.After you’ve done that, keep spending less than you earn so that you can start to sock away retirement money from each paycheck. And remember, that money is for your retirement! For tax-advantaged retirement vehicles (the best kind!) like the 401k or Roth IRA, you generally can’t take that money out before you’re 59 1/2 without paying some serious taxes and penalties (for Roth IRAs there are some exceptions that The Motley Fool can explain to you.)

However, despite having access to those legal exceptions, I want you to repeat after me: “Retirement savings are for my retirement, retirement savings are for my retirement!” Got it? Good. Let’s move on to where you should put your money to get the most out of each retirement dollar you set aside.

Tax-advantaged retirement savings – the ONLY way to go! (At least I think so.)

As I said earlier, you shouldn’t count on Uncle Sam to fund your retirement. (Even if social security is around when you retire, the pittance you receive will likely be much too small to live off, and certainly not enough to live comfortably with.) However, the government has made several investment vehicles available to the common man (or woman) that incentivize you to save for your own retirement by offering large tax savings.

The most common retirement vehicles are the 401k, 403b and IRA (Roth and Traditional.) The 401k and 403b are only available through your employer, but ANYONE with earned income can invest in a Roth or Traditional IRA.

The 401(k) and 403(b)

The 401k is frequently offered to full-time employees by a private employer while the 403b is offered to some state employees (like public school teachers) and certain non-profit employees (like church employees.) Many aspects of the 401k are similar or identical to those of the 403b. I will discuss the 401k below, but you can assume that the rules and benefits are essentially the same for the 403b. A 401k offers several advantages over a “regular”, taxable account.

Firstly, you don’t have to pay taxes on the money that you contribute to your 401k at the time you invest. This means that if you invest $4000 of your yearly income into a 401k during 2008 and you’re in the 25% tax bracket, you just saved yourself $1000 in 2008 taxes. How did I figure that? Because ordinarily you would have to pay 25% of that $4000 you made to the IRS (25% of $4000 = $1000) and would’ve only been left with $3000 to invest. Instead, you invested that $4000 in a 401k and got to keep it all to yourself! You just increased your savings by 33% because you used your 401k to invest for your retirement instead of a taxable account, that’s big money!

Secondly, every dollar you put into a 401k grows tax-free until you take it out when you need it in retirement. (Generally, you must be 59 1/2 to take money out of your 401k without penalty.) Regular, taxable accounts require you to pay taxes on the dividends and capital gains that your funds produce each year. With a 401k, as long as you leave the money in your account, you don’t have to pay any taxes regardless of how much your fund grows in value!

Lastly, many employers offer “matching” of the dollars that you invest in your 401k. A standard offer is that an employer will match 50 cents on each dollar that you put in, up to 6% of your income. This means that if you make $50,000 per year and put at least 6% ($3000 in a year) of your salary in your 401k each pay period, your company will put in another 3% of each paycheck to boot! (50 cents of 1 dollar up to 6% = 3%.) In the above example, this equals $1500 in FREE money! If you have such a 401k matching deal with your employer, max it out! This is the number one place your retirement dollars should go; no where else can you get anywhere close to this instant, guaranteed return on your money! (Unfortunately, I’ve never heard of a 403b employer offering matching to employees, so this benefit seems to be reserved for those of us lucky enough to have 401ks.)

One other thing to note, the maximum that you can personally contribute in one year to a 401k (or Roth 401k or 403b) is $17,500 in 2013. This number is set to increase with inflation in $500 increments when necessary. (And if you’re close to maxing out that number, my hat’s off to you; nice work!)

The one time that you do have to pay taxes on your 401k account is when you withdraw money from your account (after you turn 59 1/2, otherwise you’ll get hit with nasty penalties! Remember, retirement savings are for your retirement.) At this point, you’re taxed on those withdrawls just like you would be taxed for ordinary income.

However, if you believe that you’re going to be in a higher tax bracket when you retire than the bracket you’re currently in, you might wish that you could just pay the (lower) taxes on your income now, invest it, and then withdraw your money (including all the gains on that money) tax-free at retirement when your tax bracket is higher. Fortunately for you, Uncle Sam has created the Roth IRA (and the Roth 401k) for just that purpose.

The Roth IRA and Roth 401k

The Roth IRA (and Roth 401k) works in a kind of “opposite” way to the 401k (or Traditional IRA, which we’ll discuss briefly later.) Instead of investing money tax-free, you pay that taxes on the income that you invest in a Roth IRA now, but when you pull that money out, your original invested dollars PLUS all the gains on that money aren’t taxed a cent! Also, like a 401k or Traditional IRA, the money you invest grows tax free throughout all those years. Unlike a 401k, virtually anyone with some income can invest in an IRA (Roth or Traditional.) This is subject to certain income requirements which you can check HERE.

This savings vehicle could be a better place for your money than a 401k or Traditional IRA for a few reasons:

1) You expect your future tax bracket to be higher than your current one.

Ex: You currently make $30,000 a year, and are in the 15% marginal tax bracket. However, because you’ve read this blog and have become a prodigous saver, you plan on retiring at 60 with enough money so that you can comfortably withdraw $70,000 a year to live off. This amount of yearly income would put you in the 25% tax bracket. Thus, you’d be better off putting a fair amount of retirement savings into a Roth IRA (paying taxes now at 15%) so that your taxable income when you retire is likely to be within the 15% bracket, and not in the 25% bracket.

2) Your employer doesn’t offer a 401k or 403b and you plan to contribute the maximum to your IRA ($5,000 for 2012/$5,500 for 2013, with the amount set to increase in increments of $500 dependant on inflation.)

The reason you might be able to save more with a Roth IRA is a little more complicated than the last one, but there’s an excellent, clear explanation HERE.

3) You’re not sure how your future tax bracket will differ from your current one, but you just really like the idea of not having to worry about taxes when you retire!

While I completely understand this rationale, I would offer a few things to consider if this is your primary motivation for investing in a Roth IRA or Roth 401k instead of a Traditional IRA or a 401k/403b:

1) As the saying goes, “a bird in hand is worth two in the bush.” By that I mean that while your future tax savings (due to Roth IRA withdrawls) is unknown, it is certain that you will save X % on your taxable income if you were to invest in a 401k or Traditional IRA instead. (Of course, if you’re in the 10 or 15% marginal tax bracket currently, it’s hard to imagine that taxes will be lower when you retire, so a Roth IRA may make sense.)

Keep in mind, also, that some part of your income is never taxed (because everyone has access to a ‘standard deduction’ and ‘personal exemption’ that exempt about $8000 of your income from federal taxation in 2008.) So in retirement, some portion of your “taxable” retirement income (like from a 401k or Traditional IRA) will already be exempt from taxes. Thus, during the course of your working life, you probably want to invest some portion of your retirement savings into a 401k or Traditional IRA (preferably when you’re in a high yearly tax bracket, to reap the greatest tax savings.)

2) Make sure you’ve maxed out your 401k employer matching before you even think about another retirement vehicle.

(If you’d like to know more about taxes and tax brackets, click HERE. 2008 tax bracket information is at the bottom of this article for reference. Keep in mind that the incomes listed are NOT gross income ranges. They are AGI, or Adjusted Gross Income.)

The Traditional IRA

A traditional IRA is like a 401k as far as tax benefits go. However, like a Roth IRA, anyone with some income (and who doesn’t make too much money, generally you need an AGI less than ~$100,000 to qualify.) Also, the maximum allowable contribution is the same as it is for a Roth IRA, $5,000 in 2012, $5,500 in 2013.)

Note that for both Roth and Traditional IRAs, if you’re over 50 you can contribute an additional $1000 for a grand total of $6500 per year (2013) so that you can “catch up” on your retirement savings.

Conclusion and rules of thumb

Now you should have an idea of the valuable tax-advantaged retirement vehicles that are open to you, and why they are such great deals compared to regular, taxable accounts. Lastly, let me break down a few rules of thumb that you can use for your retirement investing.

1) The most important factor in retirement planning is to start investing early. Let’s take two people who are both 30 years old and would like to invest for their retirement. We’ll assume that their investment dollars grow at an annual rate of 8%. Jane decides to begin investing immediately and puts in $5000 per year for 10 years, until she’s 40 years old (a total of $50,000.) Joe doesn’t start investing until he’s 40 years old, BUT, to make up for lost time he invests $5000 for 20 years straight, until he turns 60.

When Jane and Joe turn 60 together, who do you think will have more money? Jane, who started at age 30 and invested for 10 years ends up with $365,000 at age 60. Even though Joe invested twice as much money over the years ($100,000 total), he ends up with only $247,000 at age 60.

Jane ends up with nearly 50% more retirement dollars than Joe, but only had to invest half as much! This clearly demonstrates the importance of acting now with regard to your retirement savings. A 401k (especially with matching) is a really painless way to begin this process. Just start by allocating, say, 10% or whatever you can afford of your paycheck to your retirement fund. You’ll hardly notice the difference in take home pay, but that money will really add up over time (that’s the magic of compound interest!) Try to also increase your percentage savings over time.

2) The first place your retirement dollars should go is towards maxing out a 401k employer matching plan (not everyone’s employer offers these, but be sure to check if your employer does!) This rule prevails regardless of what your tax situation is. Free money is just too sweet to pass up!

3) If you’re in a 25% or above tax bracket, and you don’t already have a large retirement nest egg built up, I would lean towards putting all or most of your retirement savings into a “NO taxes now” retirement account, like a 401k or Traditional IRA. Guaranteed savings of that much are hard to pass up. Also, as stated above, some of this money will likely be tax-free or taxed at a low rate in your retirement.

3) As long as retirement is still 5-10 years off for you, I recommend investing all your retirement savings in stocks (like 100% stock index or mutual funds.) Specifically, I recommend socking the bulk away in a large, safe, low-fee (less than 0.5%) index fund composed entirely of stocks, like Vanguard’s S&P 500 index fund (VFINX.) This also gives you instant diversification by investing you in 500 of America’s greatest businesses. One disadvantage of a 401k plan is that you must choose from the investments offered to you. If you’re lucky, a company like Vanguard, Fidelity or T. Rowe Price that offers low-fee index funds will be available to you.

If you would like to learn more on the subjects discussed above, I invite you to check out the Motley Fool’s (www.fool.com) section on Retirement. Also, if you have questions or comments on certain topics (retirement or otherwise), post a comment and I will try to reply as soon as possible.

Happy investing,

Ward Williams

Year 2008 income brackets and tax rates

Marginal Tax Rate Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household
10% $0 – $8,025 $0 – $16,050 $0 – $8,025 $0 – $11,450
15% $8,026 – $32,550 $16,051 – $65,100 $8,026 – $32,550 $11,451 – $43,650
25% $32,551 – $78,850 $65,101 – $131,450 $32,551 – $65,725 $43,651 – $112,650
28% $78,851 – $164,550 $131,451 – $200,300 $65,726 – $100,150 $112,651 – $182,400
33% $164,551 – $357,700 $200,301 – $357,700 $100,151 – $178,850 $182,401 – $357,700
35% $357,701+ $357,701+ $178,851+ $357,701+

Wanna be wealthy? “I got rules and $%&#!”

Below are some of my personal rules for putting oneself on the path to becoming wealthy.  Let me lay ’em down for you.

A definition of ‘Wealth’

And just so we’re clear, let me give my definition of wealth. To me, wealth does not necessarily mean owning a huge home, a yacht, or a professional sports franchise. It simply means the ability to be financially independent. That is, to have monetary means that allow you to live your life how you want without relying on financial support from anyone else (including an employer, family, friends, the government, etc.) Now, the way you want to live your life may mean that you need more annual income than I do, but that’s for you to figure out.

Rules for Achieving Financial Independence

Rule #1 – Spend less than you earn

1) The single most important rule to becoming wealthy is this: Spend less than you earn. It’s really that simple. The only way to build wealth is to keep some of it for yourself, and to increase those accumulated savings over time. The greater the difference between the amount you make and the amount you spend, the greater your savings, and likely the greater your wealth over time.

While this rule is simple, it is not necessarily easy. There are two ways to increase your savings: increase your income and/or decrease your spending. For most people, it is easier to decrease your spending by a significant amount than to increase your income, so let’s discuss that:

The trick is not to deny yourself the things you really enjoy in life, but to simply take a step back and try to prioritize your spending. Track your expenditures for a month, and then look at the numbers. What did you spend most on? Where can you cut back? Are there some lower cost substitutes that allow you to enjoy similar things but at a cheaper price? (I.e: checking your DVDs out from the local library for free instead of renting them from Blockbuster or *gasp* buying them. Or you could cook at home more often instead of eating out.)

Now that you’ve managed to consistently set aside some savings from your paycheck, let’s can move on to rule number two. (And hopefully these savings will increase over time, both through income increases, like a raise at your job, and expense reductions: Sell the damn boat! Take your next vacation locally! You get the idea…)

Rule #2 – Insure yourself, family and assets

There’s another important aspect of personal finance that you should have nailed down before investing: Insurance!  All that money you’re going to sock away can evaporate in what might feel like an instant if you don’t protect yourself from disaster.  And yes, you can lose your house and other assets too if you’re not properly insured!

Liability car insurance is mandatory by law, but you need to make sure you have the right levels of coverage (I think $300 – $100 – $100 is standard, but your level of coverage should depend on how much in assets you have that could be at risk if someone were to sue you.)  Also, if your car isn’t cheap like mine is (and therefore fairly easy to replace), you probably want some collision insurance as well, in case you run into a pole or someone without insurance hits you.

A key insurance area that some people overlook, especially younger people, is medical insurance.  One stay at a hospital could wipe you out financially.  Therefore, you MUST have health insurance. If you’re healthy and young and don’t have any dependents (like kids or a stay-at-home spouse), high-deductible “catastrophic” health insurance may be the right choice for you.  Check out http://www.ehealthinsurance.com to search for and compare policies.

If you have dependents (basically anyone who relies on your income) who would be in trouble if you died, get life insurance.  Many jobs offer it as a free benefit, but if the payout upon your death is not enough to look after your family, you could purchase additional life insurance as well.  If you need it, I recommend term life insurance.

[Side note: I also believe that while life insurance may be necessary, at least until your kids are through college and can support themselves, the best way to protect your family in emergencies is to build up wealth through steady investment over time (we’ll get to that later.)]

If you have property, home owner’s insurance is a must as well.  If you’re renting, consider renter’s insurance.  Personally, I’ve never used it, but I live in a pretty secure building in a decent neighborhood, and I always lock my doors!  Also, there’s nothing in my apartment that I couldn’t replace (from a monetary standpoint) should it be stolen (although it might take me a while if the thieves took everything…)

A general rule about insurance is, if you can’t afford to lose it or replace it, insure it!  (Hint: an easy way to make something replaceable is… don’t pay too much for it!  If you drive an inexpensive car, rent or own a moderately priced house, and stay away from $1000 suits or expensive watches and jewelry, then you’re exposing yourself to less risk should something happen to those possessions!  Also, for the items that you DO have to insure, like a house, your insurance payments will be less for an asset that’s less expensive.  That’s not even mentioning the obvious, large, up-front savings of making reasonably priced purchases.)

With all this being said about the importance of certain types of insurance, don’t go overboard.  Insurance companies wouldn’t insure you if they didn’t think they were getting the better end of the deal.  In some cases, you may be better served by concentrating on investing the extra money you would’ve spent on, say, renter’s insurance into an account for emergencies (like theft.)  Always shop around to get the best price and policy for your situation.  Keep in mind not only the monthly premiums, but the deductibles and levels of coverage for ANY type of insurance that you’re considering.

Rule #3 – Pay off high-interest debt ASAP!

Wanna know the best (and maybe only) way to earn a whopping, instant and totally guaranteed return on investment? Hint: It’s not a hedge fund, a penny stock or a lottery ticket, it’s paying off your high-interest debt (with an annual interest rate greater than 9-10%.)

Many credit cards have Annual Percentage Rates (APRs) anywhere from 11 to 20-something percent. By reducing and eventually eliminating your high-interest debt, you’re giving yourself an instant and guaranteed return on your money. Carrying around a $4000 balance at 20% means you’re paying $800 per year just for the privilege of carrying that piece of plastic around. (And that $800 doesn’t even include any extra fees associated with that credit card debt, like late fees, etc.)

My advice? Pick the lowest rate card you have, plan to use it only for emergencies (starting now!), and hide the rest of your cards. Then, start with the account with the highest annual rate, and pay that down aggressively until it reaches zero (then cancel that card, you really only need one or two at the most.) Next, take the account with the next highest interest rate and repeat. When you’re done with the credit cards (whew), aggressively pay down any other high interest date as well. Car loans are kind of on the border (since the rates are usually lower than 10%), but I recommend paying that off quickly as well.

Student loans with a low interest rate (preferably a locked-in rate that’s less than 7-8%) and housing mortgages (again, fixed-rate please) are generally OK debt: the less the better, but okay to just pay down in regular payments (as you should be doing already.)

[The reason this debt is ‘ok’ is that the interest rate is typically under 8% and you can get a tax break on the interest (which effectively cuts down the ‘real’ interest rate.*)]

Once you’ve paid off all your high interest debt, brief a sigh of relief and treat yourself! (Just don’t put it on plastic.) You’ve worked hard to become debt free, so stay that way! Always pay that credit card balance off at the end of the month, and if you don’t have the money for something, don’t buy it!

Now that you’ve exhausted the best available “investment” by eliminating your high-interest debt, you can move on to rule #4.

Rule #4 – Put your savings into appreciating assets (like stocks and bonds!)

Before we go any further, STOP! Have you paid off all your high-interest debt? If not, go right back to step #2 (do not pass go, do not collect $200.)

An “appreciating asset” is just a fancy term for something you own that increases in value over time. Some everyday examples would be stocks (my personal favorite), bonds, real estate, gold, CDs (Certificates of Deposit), and that Willie Mays rookie card from your Grandfather.

Now that we know what one is, the question is to what appreciating assets do you entrust your hard-earned dollars? One sensible answer would be to try to get the maximum percentage increase (known as a ‘rate of return’) possible from a particular asset. The asset ‘class’ (i.e.: category) that has historically given savers the highest rate of return is stocks (about 10.5% annually over the last several decades. This means that if you invested $10,000 at that historical rate, you’d be looking at $200,000 in 30 years, all without adding a cent to that original ten grand yourself! That’s the magic of compound interest.)

Another approach might be to pick an asset whose value not only increases, but remains fairly stable over time (like a US Treasury Bond, where the ‘principal’, or initial amount that you invest, remains constant over time. This is unlike a stock, whose entire value can fluctuate, up or down, over any given period of time.)

In order to answer “what should I invest in?” I like to break the question into two parts:

A) Where should I put my money for the short-term (less than 1-5 years)? and

B) Where should I put my money for the long-term (more than 3-5 years)?

For A, I believe the best answer is a stable investment (one where your principle will be largely preserved, regardless of what happens to the greater economy), that is sufficiently liquid, that still generates a decent return. Hopefully, this return is greater than the average annual rate of inflation, which is about 3%.

An example of this type of investment is a money market fund or a bond fund, which might return 4-6% annually. You want your investment to be liquid (easily accessible for you to use) as well, in case you need that money for emergencies in your 1-5 year time frame, or for whatever major expenses you have identified that will need to be paid for in that period. Vanguard’s Total Bond Market Fund (VBMFX) is an excellent example of a short-term investment vehicle that is highly liquid, fairly stable and has a high rate of return compared to other short-term investments.

For B, instead of looking for short-term principle preservation, we’re looking for high long-term growth in value. We want our money to increase as much as possible, so we want the highest return rate on our money. Since we are planning on socking that money away for at least 3-5 years (and preferably longer), we don’t care if the value goes up and down over a period of months, or even over a year or two. We can take more risk (a prudent amount) to earn more reward.

I believe this long-term time frame calls for full investment in stocks. The easiest, safest way to achieve this is by purchasing a broad, low-cost index fund. Vanguard’s S&P 500 index fund (VFINX) is an excellent (really) low-cost, broad index that seeks to match the return of the stock market as a whole (as represented by the S&P 500, a collection of 500 stocks of businesses that are representative of America’s entire economy.)

Another way to juice your returns is to take advantage of tax-sheltered retirement accounts. Your employers 401k (or 403b) (or a IRA or Roth IRA) provide you with ways to keep part of your precious income entirely out of Uncle Sam’s hands (legally.) If you’re in the 25% tax bracket and you invest $4000 in a 401k this year, you’ll have just saved a thousand bucks! ($4000 taxed at 25% = $1000 in taxes and only $3000 that you get to keep and invest.) Also, since you can’t dip into the money until you’re 59 1/2 without paying a huge penalty, it’s a good way to force yourself to invest for the long term.

Conclusion

So there you have it, 4 simple rules for becoming wealthy (aka financially independent.) Spend less than you make, protect yourself with the right amount of insurance (not too much, not too little), eliminate all high-interest debt (and avoid taking any on in the future), and then invest your savings in appreciating assets appropriate for both the short and long-term (taking advantage of tax-free retirement accounts.)

If you follow this recipe for wealth (it won’t always be easy, but you can do it!), I guarantee that with a reasonable return on your investments (read: historical average), enough time (which is the most important factor for big investment gains) and a sufficient savings rate (at least 10% of your paycheck, hopefully increasing with time), anyone can become a millionaire by the time they’re ready to retire.

Happy saving!

* If you pay interest of 8% on your mortgage, and you’re in the 25% tax bracket, you get back (from the IRS) 25% of the money you pay in mortgage interest each year. This means that your interest rate of 8% is effectively only 6% (8*(1 – 0.25) = 6).

Many college drop-outs are worth billions!!!

Such a title as the one above occasionally surfaces on a Yahoo!Finance or Forbes article. These articles usually throw in some statistics about the ‘growing number of college drop-out billionaires’ and name prominent college drop-outs like Bill Gates and Michael Dell (with an appropriate mention of their large net worth, of course.)

These articles often seem to suggest that a person can do just as well financially without obtaining a college degree as with. Such implications disturb me because I think they are dead wrong. I believe strongly in the value of education (formal and informal) as well as the importance of having a college degree when it comes to finding higher-paying employment than one would with only a high school degree.

The reasoning in these articles is pretty simple: “Many billionaires do not have college degrees, therefore, if you want to be a billionaire, college does not matter much.”

The reason this statement is likely false is this: College degree holders make up a much larger percentage of billionaires than they do of the general population. Therefore, those with college degrees are more likely to become billionaires than those without college degrees.
Let’s crunch a few numbers to see how I drew that conclusion. From a 2003 Forbes.com article (http://www.forbes.com/2003/07/28/cx_dd_0728mondaymatch.html):
2/3 of ‘Forbes 400 members’ have college degrees while 1/3 does not. The average net worth for these Forbes 400 members was about $2.2 billion.

However, the number of people over 25 in America WITH bachelor’s degrees was about 25% in 2003. (We’ll assume that the Forbes 400 list is mostly comprised of Americans, or that the 2:1 stats for bachelor’s:no bachelor’s is the same for American billionaires as it is for the Forbes 400.)

Therefore, bachelor’s degree holders make up only 25% of the population, but 66% of the billionaire population, whereas those without bachelor’s degrees make up 75% of the population, but only 33% of billionaires!

This means that it is 6 times more likely that a person with a bachelor’s degree will be a billionaire than a person without a bachelor’s degree.*** ^^

That’s a pretty significant difference. The above clearly illustrates that those with bachelor’s degrees are much more likely to be billionaires than those without.

Now, before you also draw the conclusion that obtaining a bachelor’s degree will make you more likely to become a billionaire, we would have to face one other fact: Smart, business-minded people, who I believe are more likely to become billionaires, probably are more likely to complete a bachelor’s degree than dumb, non-business minded people. So, if smart people are, say, 6 times more likely to finish college than dumb people, it should be no surprise that those with bachelor’s degrees are 6 times more likely to become become billionaires.

This may be true, but I suspect that even if people of equal intelligence made up the populations of those with and without college degrees, we would still see college degree holders making up more than their fair share of billionaires.

Bottom line though: Those with bachelor’s degrees are 6 times more likely to be billionaires than those without college degrees^^ (using the Forbes article data above.) Go education!

[By the way, even if you’re not interested in being a billionaire, college helps with everyday jobs as well. In the same Forbes article, those with bachelor’s degrees averaged a salary of $52,200 versys $30,400 for those without (during 1997-1999.) That’s a 72% bonus per year for having a college degree!]

*** Here’s how to calculate that from the percentages above. Pretend we have a population of 1000 people and of those 1000, 12 are billionaires (the numbers don’t matter as long as the billionaires are less than the general population.) From the stats above, 25% of people hold bachelor’s degrees (250 people) and of the 12 billionaires, 8 of them hold bachelor’s degrees. Therefore, bachelor’s degree-holders have a 8 out of 250 chance of being billionaires. 8/250 = 0.032 = 3.2%.

Let’s look at those without bachelor’s degrees: 75% of the population have no bachelor’s degree (750 people) and make up 4 of the 12 (33%) billionaires. Therefore, those without bachelor’s degrees have a 0.005333 = 0.533% chance of being billionaires.

If we take the bachelor’s degree holder probability of being a billionaire and divide it by the probability of a non-bachelor’s degree holder being a billionaire we get this 0.032 / 0.00533 = 6, meaning the bachelor’s degree holders have a 6 times better chance of being billionaires than the non-bachelor’s degree holders.

^^ Thanks to Dean Halford for correcting a faulty conclusion that I drew in an earlier version of this article. The bold, italicized statement assumes that the person with the bachelor’s degree is selected randomly from a pool of people that each have a bachelor’s degree. It also assumes that the person without a bachelor’s degree is selected randomly from a group of people that do NOT hold bachelor’s degrees.

%d bloggers like this: