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January 30, 2005

Cutting Expenses After Your Retirement

Accumulating the funds necessary to support yourself during retirement, a period that could easily span 20 to 30 years, is no easy task. But how much you need to accumulate is directly tied to your expected expenses during retirement. Go through your expected retirement expenses on an item-by-item basis. The key is to look for ways to reduce your expenses without reducing your standard of living. Consider these items:

  • Pay off your mortgage. Mortgage payments often consume 30% or more of an individual’s gross income. Eliminating this expense can drastically reduce income needed for retirement. If you can’t pay off your mortgage, consider selling your home and purchasing a smaller one for cash. Not only will you eliminate the mortgage payment, but a smaller home often results in lower utility bills, property taxes, and maintenance costs.

  • Get rid of other debts. It’s not unusual for consumer debt payments to equal 10% to 20% of an individual’s take-home pay. Try to enter retirement debt free.

  • Keep your automobile. Instead of purchasing a new car every couple of years, keep your current car for as long as it’s in good working order. That will eliminate car payments from your retirement budget.

  • Look for ways to reduce travel and leisure expenses. Look for and use senior discounts. Plan activities for non-peak times, when rates may be lower.

  • Consider relocating. The cost of living varies significantly from city to city and state to state. You may be able to reduce your living expenses substantially by moving to another locale. However, this is more than a financial decision. You also need to decide whether you want to move away from friends, family, and familiar surroundings.

Withdrawing Retirement Account Funds

After retirement, you’re likely to find that your retirement savings include several different vehicles, which might include: 401(k) plans, Individual Retirement Accounts (IRAs), profit-sharing plans, and taxable investments designated for retirement. When withdrawing funds, you need to decide the order in which to tap those accounts. Withdrawing your funds in the most tax-efficient manner can add years to their life, thus increasing your lifetime withdrawals. Typically, you’ll want to consider this strategy:

  1. First, withdraw funds from taxable investments designated for retirement. You don’t pay taxes on your principal or on any dividends or interest, since taxes were already paid on those sums. Capital gains taxes will be due on capital gains, but as long as you’ve held the asset for over a year, that tax rate is 15% (5% for those in the 10% or 15% tax bracket), which is likely to be lower than your ordinary income tax rate. When deciding which assets to sell, consider those with lower capital gains.

  2. Next, make withdrawals from your tax-deferred investments, including 401(k) plans and traditional IRAs. If some of your traditional IRAs were funded with nondeductible contributions, withdraw those first, since a portion of your withdrawal won’t be taxed. Withdrawals from these accounts are subject to ordinary income tax rates. Keep in mind that you’ll typically need to start taking minimum required distributions by age 70 1/2. The only exception is that those still working can delay distributions from qualified plans (not IRAs) until retirement.

  3. Last, use funds in your Roth IRA. Since those funds grow tax free, let them continue to grow as long as possible. You may even want to convert all or a portion of your traditional IRAs to a Roth IRA. Even though you’ll have to pay income taxes on the taxable portion when you convert the balance, your funds will grow on a tax-free basis. Since you aren’t required to take minimum required distributions from a Roth IRA after age 70 1/2, this option may be more appealing to those who don’t need the funds for retirement and are interested in tax-advantaged ways to transfer those assets to heirs.

Of course, your specific situation may dictate a different method of withdrawal. For instance, it may make sense to use your tax-deferred accounts first if your assets have very large capital gains. You may want to bequeath the assets with large capital gains to your heirs so that the assets’ basis will be stepped up to market value after your death. Or, in years with low income, you might lose some of your itemized deductions or personal exemptions unless you make withdrawals from your tax-deferred accounts to recognize additional income for tax purposes. Individuals in high marginal tax brackets with large tax-deferred balances may find it makes more sense to spread out withdrawals from these accounts to minimize lifetime tax payments.

January 15, 2005

Is An Interest-Only Mortgage Loan Right For You?

Although interest-only mortgage loans have existed for many years, they have increased in popularity recently. With home prices continuing to rise and interest rates still at low levels, an interest-only mortgage allows homebuyers to purchase a larger home with a smaller mortgage payment.

Basically, for a fixed period, you only pay interest on your mortgage. The interest rate may adjust with changes in the prime rate or be fixed for a designated period. During that period, you can typically make payments against principal at your discretion. At the end of the interest-only period, the mortgage may convert to a traditional fixed-rate mortgage payable over the remaining period of a 30-year term. Since you are amortizing the entire principal over a shorter period, the monthly mortgage payments can be significantly higher than on a traditional 30-year mortgage. Sometimes, at the end of the interest-only period, the entire balance becomes due, so you must refinance at that time.

Several types of homebuyers may be interested in this type of loan, including those who expect their income to increase significantly over the interest-only period. The lower initial payment allows them to afford a larger home. When the payments go up at the end of the interest-only period, increased income should cover the increase in the mortgage payment. Homeowners with uneven income, such as those who own their own businesses or earn commissions, may find the lower payments helpful during periods when income is lower. When their income increases, they can send additional principal payments in with their interest payments. Other homeowners may like the ability to use funds that would have been paid toward principal for other financial purposes, perhaps to fund a retirement plan or a child’s college fund.

Before applying for an interest-only mortgage, be aware of the risks:

  • Your payments can still increase during the interest-only period. Many interest-only mortgages are tied to the prime rate and will increase as the prime rate increases. Over a period of years, your payment can fluctuate significantly, especially if your mortgage has high caps on interest rate increases.

  • Because you are only paying interest, your mortgage payments do not build equity in your home. Historically, increasing home prices have provided a significant portion of a homeowner’s equity, but increases in home prices are not guaranteed. If home prices stagnate or decline, you may owe more on your mortgage than you can sell the home for.

  • Once the interest-only period is over, the mortgage payment may increase substantially. If your income doesn’t rise during that period or one spouse quits working, you may have difficulty finding the resources to pay the higher mortgage payment.

Signs It's Time To Sell A Stock

It’s always difficult to determine the proper time to sell a stock. What if you sell and the stock price increases dramatically? Or what if you hold on to the stock and its price goes nowhere or declines? To help you decide when to sell, consider these signs:

  • The price of a stock with a large loss isn’t moving. Investors hate selling a stock with a loss, often wanting to hold on until they at least break even. However, just because the stock sold at a much higher price in the recent past doesn’t mean it will hit that price again anytime soon. You may want to sell and reinvest in another stock with better prospects. To help make that decision, forget what you paid for the stock. Instead, analyze it at its current price, deciding whether you would purchase it today at that price.

  • The stock has hit your target sell price. When you purchase a stock, set both high and low target sales prices. While you don’t have to sell when the stock hits those prices, you should at least review it at that time. You might want to set rigid rules for selling a stock when it declines by a certain percentage of your purchase price, to ensure you don’t incur substantial losses. Many investors find it emotionally difficult to sell a stock at a loss, so this rule can take the emotions out of that decision. Keep in mind that capital losses can be offset against capital gains, and an excess of $3,000 can be deducted against ordinary income. Any remaining capital losses can be carried forward indefinitely.

  • The stock’s fundamentals have changed. The world is constantly changing and the market leaders of today may not be the market leaders of tomorrow. Thus, watch your stocks so you can spot when fundamentals may be shifting.

  • The stock is subject to negative news stories. You shouldn’t sell a stock at the first sign of trouble, since it’s not unusual for a stock to go through a difficult period. But if the news is continuing and involves significant events like management shakeups, major competitors stealing market share, unwelcome mergers or acquisitions, or top executives selling large blocks of stock, it’s time to reevaluate the stock.

  • The stock’s price has run up too much, too quickly. While this is a good event, the price could have risen so significantly that you may not think it has the potential to increase much more in the future. At that point, you may want to sell and purchase another stock with better prospects.

If you have difficulty implementing your sell strategies, call for a second opinion. Often, discussing your thoughts with someone else causes you to consider other factors or helps ensure your reasons for selling are valid.

Reevaluating Your Investment Portfolio

Periodically, you should thoroughly review your portfolio to ensure it is still helping you work toward your investment goals. Follow these steps during that review:

  • Review your current portfolio mix. List the current value of all your investments. Determine what percentage of your portfolio is held in stocks, bonds, cash, and other investments, but don’t stop there. Take a closer look at where the stock portion of your portfolio is invested. Break down your stock investments by market capitalization (small-, mid-, and large-cap), by style (growth and value), by area (domestic and international), and by sector (technology, financial, utilities, energy, etc.).

  • Analyze each investment. Determine whether it still makes sense to own each investment. Don’t let emotions get in the way. Review why you purchased each investment and whether those reasons are still valid. Emotionally, it is difficult to sell an investment at a loss, but holding on until you get back to break-even may not be the best strategy. The investment may never get back to that price or may take an excessively long time to do so. You may want to sell the investment and reinvest in another with better prospects. Instead of worrying about what you paid for the investment, decide whether you would buy it today at its current price.

  • Determine if changes are needed to your current allocation. If we’ve learned anything over the past few years, it’s that your portfolio should not be highly concentrated in one area or sector. Instead, look to broadly diversify your portfolio. Some points to consider include:

    Decide how much to allocate to stocks and bonds. Your stock and bond mix is a major factor in determining your expected portfolio return and how much your portfolio will fluctuate with market movements. However, be careful not to let recent events cause you to allocate too much to bonds just to avoid stock market fluctuations. Make this decision based on your financial goals, risk tolerance, and time horizon for investing. If you are investing for the long term, say 10 years or more, you probably still want a major portion of your investments allocated to stocks.

    Reassess your stock allocation. Is your stock portfolio too heavily weighted in technology stocks or blue chip stocks? Have you selected only growth stocks, ignoring value stocks? Do you prefer large-cap stocks, ignoring smaller stocks? The stock market moves in cycles, with different sectors outperforming other sectors at different times. Since no one can predict when one sector will outperform, it is typically best to broadly diversify your stocks over all areas.

  • Move your allocation closer to your desired allocation. When making changes, first consider the tax ramifications of the transactions. If you can make changes without incurring tax liabilities, you may want to make the changes immediately. But if substantial tax liabilities will be incurred, look for other ways to get your portfolio closer to your desired allocation. For instance, any new investments should be made in areas that are underweighted in your portfolio. Or you may be able to reallocate in your tax-deferred accounts, such as Individual Retirement Accounts (IRA’s) and 401(k) plans, where you typically won’t incur tax liabilities. However, if you can’t get your allocation in line within a year using these approaches, you might want to sell some of the poor performers and reinvest the proceeds.

Get Your Spending Habits Under Control

If you’re trying to increase savings, remember that savings are directly tied to spending — the less you spend, the more you have to save. Some tips to consider to help get your spending under control include:

  • Analyze your spending practices for a month. Are you surprised by how much you spend on dining out, groceries, entertainment, or clothing? Give serious thought to your purchasing patterns, looking for ways to reduce spending. Clean out your closet and really assess whether you need more clothes. Cut back on how often you eat out or at least dine at less expensive restaurants. Rent a movie instead of going to a theater. Make a list before grocery shopping and don’t deviate from it. Look for coupons and sales before shopping.

  • Go over major expenditures as well. When was the last time you comparison shopped your auto or homeowners insurance? Have you checked mortgage rates recently to see if you should refinance? Have you reviewed strategies to reduce your income taxes?

  • Make a spending plan and put it in writing. Budget for all major expenditures and resolve not to purchase items that aren’t in the budget. Monitor your actual spending against your budget during the year to make sure you are staying on track.

  • Throw out your credit cards (or at least hide them for a while). Most people find it more difficult to spend cash than to charge a purchase. So, for the next couple of months, only purchase items with cash.

  • Only purchase items over a fairly low dollar amount on your second shopping trip. How often have you purchased something on impulse, only to realize when you got home that you really didn’t need it? To control those impulses, compare price and value on your first shopping trip. Then go home, think about whether you really need the item, and purchase it on another trip.

  • Think carefully before making major purchases. Often, upkeep and maintenance will add to your costs. Do you really need a motorcycle, boat, recreational vehicle, or vacation home? Consider a less expensive car or a used car. Keep your car for four or five years instead of getting a new one every two or three years.

  • Figure out the maximum amount you can afford for a house and then buy one substantially less expensive than that. Not only will you save on your mortgage payment, other costs associated with owning a home will be lower. Living well within your means is one of the best ways to ensure you have money left over for saving.

Your Path to Your Financial Goals

By definition, achieving your financial goals requires the accumulation of financial assets. How quickly you accumulate the needed assets depends on three things: 1. How much you earn; 2. How much you save; and 3. How well you invest.

  1. How much you earn. Sure, we all want to enjoy our work. But within that parameter, why not choose a job that will pay more? Your income is going to drive all your other financial decisions, so investigate your options.

    Are you sure you’re being paid a competitive wage with competitive benefits? Even if you aren’t interested in changing jobs now, pay attention to what is going on in your field.

    Do you have an outside interest or hobby that can be turned into a paying job? This could be a good way to supplement your current salary. It may also turn into a part-time job or business after retirement.

    Can you get some additional education or training to help secure a promotion or qualify for another job? Read up on which jobs are expected to have the highest growth rates and/or highest salaries over the next few years. If you don’t enjoy your current job, you have even more incentive to implement these suggestions.

  2. How much you save. You should be saving a minimum of 10% of your gross income. But don’t just rely on that rule of thumb. Calculate how much you need to meet your financial goals and then determine how much you should be saving on an annual basis. If you can’t seem to save that much, consider these tips:

    Reduce spending, diverting that money to savings. See the article “Get Your Spending under Control” for more details.

    Invest all unexpected income. Instead of spending money from tax refunds, bonuses, and inheritances, invest the money immediately. You may also want to put any salary increases into savings, possibly in your 401(k) plan.

    Save regularly so it becomes a habit. One of the best ways to save regularly is to make saving automatic. If you have to remember to write a check every month, it’s easy to forget or not get around to. It’s usually easier to have the money automatically deducted from your bank account and deposited directly in an investment account. Another good alternative is to sign up for your company’s 401(k) plan, having funds withdrawn every paycheck. (Keep in mind that an automatic investing plan, such as dollar cost averaging, does not assure a profit or protect against a loss in declining markets. Because such a strategy involves periodic investment, you should consider your financial ability and willingness to continue purchases through periods of low price levels.)

  3. How well you invest. To ensure that your savings grow, you need to invest them wisely. Consider these tips:

    Set an asset allocation strategy for the long term. The most basic investment decision you’ll make is how to allocate your portfolio among the various investment categories, such as cash, bonds, and stocks. You want to ensure your portfolio is diversified among a variety of investments. That way, when one category is declining, hopefully other categories will be increasing or not decreasing as much. To decide how to allocate your portfolio, you’ll first need to come to terms with your risk tolerance. Factors like your time horizon for investing and return expectations will also impact your decision.

    Thoroughly review each investment in your portfolio. Decide whether you should continue to own it based on your financial goals and asset allocation strategy. Also make sure your investments are adding diversification benefits to your portfolio.

    Maintain reasonable return expectations. The higher your expected return on your investments, the less you need to save every year. However, if your assumed rate of return is significantly higher than your actual return, you won’t reach your goals. Thus, it’s important to use reasonable return expectations. Assess your progress every year so you can make adjustments along the way. If your return is lower than expected, you may need to increase your savings or change investment allocations.

    Review your portfolio at least annually. Your portfolio won’t stay within your desired allocation by itself. Since different investments earn different rates of return, over time your allocation will get out of line. You need to review your portfolio periodically and make adjustments to rebalance it.


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