Is physical fitness on your list of New Year’s resolutions? How about fiscal fitness? Along with doing those hundred sit-ups each day, how about planning to save a hundred dollars each month? In addition to vowing to exercise in 2004, how about exercising your ability to eliminate credit card debt from your personal balance sheet? A few sacrifices now may mean a more comfortable retirement for you later.
Retirement may seem a long way off for those early in their working lives, but that’s no reason to put off planning for it. The immense power of compounding is the strongest ally for young investors. Even the market ups and downs can work in an investor’s favor if she invests a fixed dollar amount each period (so that more shares are automatically purchased when prices are low, and fewer shares purchased when prices are high).
Let’s say Sarah begins contributing $100 per month to a tax-deferred account at the age of 21, while her co-worker, John, waits until the age of thirty before beginning to think about retirement, and then contributes $200 per month. If both earn an average return of 8 percent on their money, and both retire at age sixty, guess who retires with the larger portfolio? Sarah will have accumulated $321,196.63, having contributed only $46,800. John will trail with $298,071, having contributed $72,000. Starting early and investing consistently are the keys to future financial health.
I remember my first few years on the job with a major brokerage firm nearly twenty years ago. I passed up the 401k plan and the Employee Stock Option Plan (ESOP). I wasn’t planning on staying long enough to benefit from those rigid plans administered by my own company. A few years later, however, I realized my mistake and jumped onboard. The 3 percent company match in the 401k plan was essentially free money. Don’t make the same mistake I did — take the free money!
If your company doesn’t offer a 401k plan, or even if it does, there are additional ways to save for retirement. The Roth IRA may be the best vehicle for retirement savings ever created. “The Roth IRA offers ten times the tax efficiency of a regular IRA,” says Bradley Haupt, a tax and financial adviser in Pleasanton. Any working person can contribute up to $3,000 per year (as long as they’ve earned at least that much in income and qualify within certain income limits). There is no tax benefit in the year of the contribution, but the money saved can grow tax-free forever. That means that once you reach the age of 591/2, you can begin drawing the money out of the Roth IRA account without paying any tax on any of it. There is no minimum or maximum amount that has to be taken, and no restriction on how it can be spent. In 2005, the law will allow contributions to reach $4,000 per year, rising to $5,000 in 2008. There are penalties and taxes for taking out the money early (except in special circumstances), so just forget about it once you’ve set it aside.
What’s the biggest risk facing young investors? “Doing nothing is by far the biggest risk,” Haupt says. Inflation is the reason that doing nothing is such a big risk. It erodes the buying power of your cash savings. Just ask your parents how much they paid for their first home. Chances are you’d have a hard time buying your favorite new car today for the same price. That’s inflation. History has shown that a well-diversified stock portfolio is one of the best ways to stay ahead of inflation. Although it has been relatively dormant in recent years, Haupt warns that “there will be another round of inflation in the not-too-distant future.”
Investors nearing retirement have learned a painful lesson since the market highs of 2000 — the market also can go down. Even some well-diversified investors have taken as much as a 50 percent blow to their nest eggs, and are now forced to work well past their intended retirement age. Unfortunately, that lesson may have been learned too well by the younger generation, now timid about investing in stocks. They have the one advantage that those retirees and near-retirees didn’t have — time. Over long periods of time, stock market volatility becomes more muted and returns become more reliable.
Investors can research and select their own investments using discount brokers such as Charles Schwab, Fidelity, or E*TRADE. Or they may feel the need for more personalized attention. In this case, full-service brokers from firms such as Merrill Lynch, Morgan Stanley, or Smith Barney might do the trick. Additionally, fee-based investment advisers and financial planners can provide personalized service at competitive prices (usually 1 to 2 percent annually, depending on account size). It’s important to get referrals from someone you trust.
Buying a home is usually high on the list of priorities for young families, as well it should be. Home ownership provides not only a comfortable shelter, but substantial shelter from income taxes. Interest payments on a home mortgage are deductible as an itemized expense on your tax return. Additionally, purchasing a home with only a down payment (usually 10 or 20 percent) provides leverage. Let’s say a home is purchased for $100,000 (yeah, right — maybe in Winnemucca!) with a down payment of $10,000. If the home appreciates at only 3 percent per year, it will be worth $103,000 the following year. With an investment of $10,000, and an after-tax mortgage payment no larger than rent payments would otherwise be, that’s a return of 30 percent on your money.
It’s a good idea to set aside some cash in a regular savings account for that future down payment. It’s also a good idea to be nice to your parents. A large portion of the down payment can be in the form of a gift from mom and dad, although government regulations typically require at least 5 percent of the purchase price to come directly from the buyer’s savings.
Maintain a good credit rating. “Pay your bills on time,” warns Linda Grassi, a mortgage broker with the Home Loan Group in Castro Valley. “A good credit rating cannot only make the difference between qualifying and not qualifying for the loan, but can make a difference of two or three percentage points on the interest rate.” Additionally, borrowers with good credit scores may qualify for better terms on the loan. Get a copy of your credit report periodically and correct any mistakes.
Individuals and young couples who haven’t yet built up a sizable net worth may not have given much thought to estate planning. “For estates of less than $100,000, a simple will is the typical choice,” says Alameda estate planning attorney Heather Tremain. “It identifies who gets what and, for parents, it identifies a guardian for the children.” More complex estates may prefer a Living Trust. There are issues of privacy and tax ramifications for each option. She also recommends a few additional documents for everyone. “Anyone who has a body,” she says, should have an Advance Health Care Directive. This document allows you to designate someone to make health-care decisions for you if you become incapacitated. Tremain also recommends a Durable Power of Attorney for Finances, which allows another person to handle your finances if you are unable to do so. This would include important things such as paying bills, paying taxes, and selling or refinancing a home.
In addition to health insurance, which everyone should have, some young investors may consider life insurance or other annuity products. Your twenties and early thirties are considered the critical period. “This is because the next 20 to 25 years will be when people encounter their largest financial burdens,” says Richard Mayeri, a licensed life and health insurance agent in the Monterey area. He recommends term life insurance for parents and married couples with a mortgage. This protects the surviving spouse and/or children in the event of a loss of the primary breadwinner. Term life insurance guarantees a fixed payout of insurance in the event of death of the insured during a specific period of time (usually ten or twenty years). “Term life,” Mayeri stresses, “gives people the most insurance for the least amount of money.”
Finally, for young parents, saving for college may be a priority, especially with tuition costs rising at an astounding 14 percent in just the last year. Eighteen years from now, the cost of four years at a public school will likely top six figures. If you still have money laying around to invest for college, consider a 529 Savings Plan. Each state offers its own, but you may invest in any state’s plan, and the child may attend college in any state. California’s plan is administered by TIAA-CREF, a reputable no-load mutual fund company. There are no income limits and generous contribution limits ($250,000 in some cases) for these types of accounts. You can usually select a portfolio based on your risk tolerance: aggressive, moderate, or conservative. Or you can let the plan adjust the portfolio based on the child’s age. There may be some tax benefits to investing in your own state’s 529 Plan.
But who says parents are obligated to put their kids through college? Unlike retirement, which you generally have to finance for yourself one way or another, students planning to attend college have a number of additional options. Your child may qualify for a scholarship or grant. She also may be eligible for financial aid, student loans, or work-study programs. Don’t let college tuition costs keep you up at night. You’re better off focusing on sound financial principles and saving for retirement. But don’t delay. Even if you have only begun to think about some of these issues, it’s important to take the first steps forward as soon as possible. And while you’re at it, why not do a few sit-ups? n
Tyler Ribera is president of RIBERA Investment Management, LLC, an independent investment advisory firm in Hayward. He can be reached at [email protected]