Psychology of Personal Finance

Investopedia has an interesting article on Behavioral Finance. While much of the article discusses behaviors particular to investors such as herd behavior, there are behaviors which can effect anyone's finances.

One behavior is mental accounting. This is treating money differently. "Found money" such as an income tax return can be splurged while money that was earned is more valuable.

Prospect theory is how we react to certain events, treating negative events as more significant than positive ones. For example, someone who gains $100 and then loses $50 is unhappy while someone who only gained $50 is happy, even though they're even in terms of results.

Check out the behavioral finance article and see if any of its concepts apply to you.

Future Programming for Analog TV: Snow

An acquaintance commented last night that her TV broke. When she went to buy a cheap one, there were none to be found. In the group conversation that developed, no one was aware that analog TV broadcasts stop in just 17 months, on Feb 17, 2009. Only digital TV broadcasting will remain after that date. Right now it is illegal to sell a new set that doesn't include a digital tuner.

So what do you do if you have an analog TV set? If your TV reception goes through the cable company, then the issue is up to them. Your existing converter box probably will continue to work. On the other hand, if you use an antenna then you will have to do something yourself.

There is a Digital-to-Analog Converter Box Coupon Program scheduled to begin next year. Under this program, all US households will be eligible to request two $40 coupons towards converter boxes. These boxes are expected to retail for approximately $60 each, but are still under development.

If you use an antenna and want to use your analog set, I recommend that sometime next year you take advantage of this program. You may want to wait a few months for prices to stabilize. Next summer may be the optimum time. If you use rabbit ears you may find that a roof-top antenna is necessary. That has been my experience with a digital TV as I'm in a fringe area. While analog TV degrades into snow and perhaps ghosts, digital TV is perfect and then with degraded signals you might see a bit of pixelization, and a dark screen. Don't wait until the last minute to sort this out.

Reasons For Not Participating in a 401(k) Plan

Occasionally the topic of retirement savings comes up at work. I'm amazed at some of the thinking.

One colleague made the comment that if he had $50,000 he could retire. Being an immigrant, I thought perhaps he was planning to return to his home country and live in a mud hut. But I didn't pursue the topic. Then a couple of years later, he was looking at needing to retire and told me that all he had was Social Security. When I asked about his 401(k) he said that he wasn't participating. When I asked why he said "It might go down". Well, with a 50% employer match and 100% match after 5 years, it has to go down a lot to lose money. And if afraid that "it might go down" the plan offers a money market fund. So he lost out on the employer match for 6 years at this employer. And with the relatively small amount he could have saved, he would pay very little if any taxes on his distributions if he spread it out over a number of years.

Another fellow employee told me that he wouldn't participate because he didn't want his money in our employer's stock. Yes, it's a good idea to diversify. But beginning last year, those who were vested had the option to sell their company stock and chose other investments. After the conversation, I got to thinking that maybe he thought his contribution had to be invested in company stock. Which was never the case, although that has always been an option.

Another colleague who is participating thought that the only way to get funds of the employer match out of the company stock was to pursue our unique option of being able to have up to a certain limit distributed each year -- he wasn't aware of the plan change last year allowing diversification.

Before making decisions about participating in your employer's 401(k) plan, get a copy of the Summary Plan Description and read up on the rules. And if it's been awhile since you've read yours, get a fresh copy because they can be amended periodically, and review the information there.

Any other excuses for not participating?

I Wonder if Ray Got a Letter Too

The Federal Trade Commission has published a press release "FTC Warns Mortgage Advertisers and Media That Ads May Be Deceptive". On this page is a link to a sample letter they sent out.

The press release included the following:

For example, some ads touted rates as low as “1%” but failed to disclose adequately:

* that the stated rate was a “payment rate” – not the interest rate – that applied only during the loan’s initial period;
* that low advertised payments applied for only a short period; and
* the loan’s Annual Percentage Rate, the uniform measure of the cost of credit that enables consumers to shop for and compare mortgage offerings.

Some ads promoted only incredibly low monthly payments but failed to disclose adequately the terms of repayment, including payment increases and a final balloon payment.

I wonder if Ray Vinson got one about his "No-Spin Mortgage". Perhaps so -- I haven't heard any such ads from him or Bill O'Reilly recently. I was never able to find out any details about his loans on his web site, just an application form. What do you think the chances are that I would have found out if I'd taken the trouble to apply?

While over at the FTC website, you might want to check out their page with links to articles with consumer information about mortgages.

How and Why I Rolled Over 401(k) Funds to a Roth IRA

Actually I didn’t do this exactly as I’ll explain later. First I’ll discuss the “why”.

As I discussed in this post, you should have some of your retirement funds in tax-deferred savings such as traditional IRA or 401(k) funds. This is because some taxable income is not actually taxed. The taxable income on which you pay no taxes at all is that which is less than your personal exemption and standard deduction. The standard deduction amount is increased slightly for someone 65 or older. This adds up to almost $10,000 for a single person over 65 in 2007, and this amount is indexed annually for inflation.

However, the effective tax rates for a retiree can quickly escalate once taxes are paid. If other income including withdrawals from tax-deferred savings added to 50% of your Social Security benefit exceeds $25000 for a single person, you begin paying taxes on $.50 of Social Security for each $1 of additional other income. With even more income, you pay taxes on $.85 of Social Security for each $1 of additional other income. This can effectively turn a 15% tax bracket into 22.5% or 27.75%, and a 25% bracket into 37.5% or 46.25%. It would be terrible to pay 46.25% taxes on money you deferred at 25%. Also, the $25,000 threshold for testing whether or not some of your Social Security is not indexed for inflation which will result in more and more people paying more taxes on Social Security benefits.

Once you reach the age of 70 ½, the IRS expects you to take Required Minimum Distributions (RMDs) from your tax-deferred accounts. Failure to take your RMDs can result in punishing penalties -- 50% of the amount you were supposed to have distributed but did not.

I have sufficient tax-deferred savings that I’m concerned about ending up in an effectively higher tax bracket due to taxation of my Social Security benefits. I am also concerned that tax rates will increase in the future as right now they are at historic lows. So I am converting 401(k) funds to a Roth IRA, but as I stated earlier I couldn’t do this exactly, or at least not directly. First I had to rollover the 401(k) funds to a rollover traditional IRA and then I converted funds from the rollover IRA to a Roth IRA.

My employer’s 401(k) plan rules allow me to distribute up to $25,000 per year of the company match. Most people probably don’t have this option, but I did. However, you may have funds from prior employers that you’ve either left with them or have already rolled over to an IRA. (If you spent them – shame on you.)

Last year, I created a rollover account at Vanguard which initially was unfunded. Then I contacted my 401(k) plan administrator and asked for a partial distribution with the check made out to Vanguard as the custodian of my rollover account. By having it made out to my IRA custodian I avoided having taxes withheld from the distribution. The check was mailed to me. I then placed it in an envelope with a form I downloaded from Vanguard’s site and filled out with my personal and account information to fund the rollover IRA account I had setup previously.

Later on and before the end of 2006, I converted part of my rollover account to a Roth IRA account which I had previously set up and funded with normal IRA contributions. The part I didn’t convert is still in my rollover IRA. The amount that I converted to Roth added to my tax bill. In order to avoid penalties for underpayment of taxes, I made sure to increase tax withholdings from my salary to exceed the amount I had paid in taxes the prior year, and I went ahead and had enough withheld to cover the taxes on the amount I converted to Roth. I estimated this with a spreadsheet and actually ended up with a small refund due to the telephone tax refund.

In retrospect, I should not have done this with my current employer’s 401(k). I have funds left in a prior employer’s 401(k) plan. I should have started my conversion with those funds. The reason is that if I leave my current employer during or after the year I turn 55, then I can withdraw plan without penalty from my 401(k) sponsored by that employer. I don’t have that option for employer’s I’ve left at a younger age until I reach 59 ½. I also don’t have that option with funds that I’ve rolled over. While taking and spending distributions from my 401(k) is not currently in my plans – well, life happens and it’s good to have options.

I want to reiterate a few points for someone contemplating doing this.
(1) Make sure that you have enough tax-deferred savings or a taxable pension so that when in retirement you use up the standard deduction and personal exemption amount on which you wouldn’t pay taxes anyway.
(2) Make sure the distribution is directly to your rollover account custodian to avoid withholdings.
(3) Plan your income tax withholdings and/or estimated tax payments so that you don’t get hit with a large tax bill and possible penalties the following April.
(4) If you have funds in any traditional IRA which are after-tax, the complexity of your tax returne will increase. Those funds are “non-deductible contributions” to a traditional IRA, see IRS form 8606 that will need to be filed if you do a conversion.
Another consideration is that the funds I’ve converted must remain in my Roth IRA for 5 years or I will pay a penalty.

This year I plan to rollover funds from my prior employer's 401(k) plan and convert them to Roth. I understand that beginning in 2008 that the "two step" won't be required and that 401(k) funds can be directly converted into a Roth IRA. While my employer offers a 401(k) plan with some great funds, I hope they make it even greater by adding a Roth 401(k) option.

Your Dinner is About to Be Interrupted

Having my evening interrupted with telemarketing phone calls is an unpleasant but receding memory. Many states including my own passed do-not-call legislation in 2002. The fine print is that the registrations for the lists automatically expire after 5 years. After all, many people move and we don't want the person who "inherits" the old number be deprived of the wonderful experience of having their dinners interrupted by someone pitching timeshares. So if you signed up for your state's do-not-call list in 2002, that registration may be expiring if you didn't sign up again. Wisconsin and Pennsylvania are two such states.

The national do-not-call legislation was enacted in 2003 also with a provision for 5-year expiration of registrations, so if you've registered for that list your registration is still in effect and won't expire before next year.

Last year I got a now-rare phone call from a telepest. After giving them a hard time and filling out a complaint on the web site of my state attorney-general, I checked-up on my registration to make sure it hadn't expired. While I was at it, I went ahead and re-registered my phone number protecting me until 2011.

If you haven't registered your phone number on the national do-not-call list, you should do it now. Even if you have already registered, why not re-register it now that you're thinking about it so that you won't have a gap in your protection next year if you forget to renew it?

The registration process is fairly simple. Just go to the National Do Not Call Registry and fill in their form. You will need to give them an email address to verify your registration. Make sure that you follow the instructions in the email to compete the registration process. The web site also offers the capability to verify your registration.

No 401(k) for Snow

In a recent post, I discussed the Zeroeth Law of Financial Security (spend less than you earn)and gave the example of Tony Snow not being able to make it on $168,000 per year.

Seems it's even worse, according to this editorial. While not the main point of the editorial, it stated:
......., it was clear that he had relied entirely on others to save for his retirement. Snow conceded: "As a matter of fact, I was even too dopey to get in on a 401(k). So there is actually no Fox pension. The only media pension I have is through AFTRA [a union]."

Tony needs to get serious about his own personal finances, or hope that the union pension is lucrative. Even maximum Social Security benefits if he waits until the age of 70 to start them will be less than 24% of the $168,000 he couldn't get by on. And the benefits would be about the same as an average worker makes.

Hopefully Tony will beat his cancer. If so, I expect we'll be seeing him on Faux News for a long time to come.

Improving Your FICO Score -- Correcting Errors

FICO scores are determined from data in your credit report. But many credit reports are in error. When I became aware several years ago that you could get a copy of your own credit report free from www.annualcreditreport.com, I pulled a report from one of the 3 credit-reporting agencies. When I saw the errors present in my report, I wrote a letter and had the errors corrected. I also pulled the reports from the other 2 agencies, found errors in them and wrote letters to have them corrected as well.

Since then, I spread out my reports among the 3 agencies, getting a sample from one of them every 4 months to get a heads-up if there's a problem. While I'm not in the market for loans, FICO scores can effect other aspects of life such as insurance premiums, and can even keep you from getting a job.

In my case it was fairly easy to get the errors corrected. Perhaps your situation is a bit more complicated. Check out this MarketWatch story How to Correct Your Credit Report for a six-step guide.

FICO scores are less of a concern. Paying your bills on time and not over-utilizing your credit line will go a long distance to getting you that high FICO score. And correcting errors may help as well.

Which Came First, the FICO Score or the Loan?

How does someone without a credit history obtain a loan? It's sort of like asking whether the chicken or the egg came first. I remember the difficulty I had in getting my first credit card -- and this was after I had obtained a mortgage. I was turned down even when applying as a student, not for a poor credit history but for no credit history. This was around the time FICO scores were introduced.

According to this article in the Kansas City Star, an alternative scoring method is being developed based on an individual's payment history for utility bills, rent payments, and even payday loans.

This alternative scoring method is not yet accepted by all lenders. However it may provide more options to those trying to break through the credit history barrier to get their first credit card.

Driving a Car to Death Saves You ... How Much?

The headline of this CNN article says that it's $31,000. Compared to the cost of trading in and buying new every 5 years, keeping a Honda Civic EX for 15 years saves you $20,500. The car used in this example is a Honda Civic EX -- the Civic is one of Honda's cheaper models and the EX is a package that adds power windows, automatic transmission, etc. The other $10,300 comes from interest before inflation on your savings, savings at 5% and inflation at 3%. Personally, I prefer to leave inflation out of it -- but the $20,500 of savings is enough motivation. That's over $1300 per year that can be added to retirement savings.

I have a Honda Civic DX which has basically nothing extra, except for air conditioning and a CD player. I don't mind cranking up the windows by hand or shifting the transmission myself. My other vehicle has power windows two of which have required expensive repairs. I get better gas mileage with standard transmission, in the mid 30's around town and easily over 40 mpg on a long trip. The only feature I miss in my basic car is cruise control when on a long trip. I considered Honda's hybrid model, but estimated that the $5000 extra it cost would not be repaid by reduced gas consumption, even with rising gas prices.

In order to keep your vehicle for 15 years, it has to hold up. Regular maintenance goes a long ways, some of which is relatively simple such as checking your fluid levels regularly. The make of the vehicle is a factor: some of the longest running cars are made by Honda. On the other hand, some luxury vehicles such as BMW, Jaguar, and Mercedes are less likely to last 200,000 miles. (Here's the other assumption in the article: driving around 13,000 miles per year.)

I've had my Honda for almost 3 years and have put over 36,000 miles on it. I've had zero problems with it, compared to an American vehicle that required several trips back to the dealer for repairs, the first within 30 days.

Most people make car payments and view the cost of ownership as the amount of the monthly car payment (after you've paid off the note it's free). Their view of the cost to go on a trip is the cost of the gas. I have a different model. I've paid cash for my last two vehicles. I estimate the depreciation as the cost of the car divided by 100,000 miles. Each month I look at the odometer and plug the number into my spreadsheet. The spreadsheet calculates how much I need to set aside to buy the next car. I expect the car to last more than 100,000 miles, but also expect that repairs will be needed more frequently as the miles pile up. And when it's time for a new vehicle, I have the money to pay cash for it. And with my financing model, I think a bit more about the cost before deciding to take a trip.

Perhaps some people look at me as I drive up in my appliance-white small vehicle and assume that I don't have much money. But I don't care about impressing anyone. I get more satisfaction from a higher balance in my 401(k).

My Net Worth Says "Ouch"!

Here's a chart of my latest net worth estimate. Ouch!! My 401(k) (pink area at the top) took a hit from the recent stock market decline.

For now though, I'm remaining in the stock market, my 401(k) plan offers some good index funds.

I haven't made any adjustment to my property value (area in green) yet. I have been basing the value of my house on the tax appraisal that comes out one a year. Given the housing market slowdown due to the credit crunch, I'd expect that to happen. But the cynic in me suspects that they'll never reduce the tax appraisal.

The Retirement Reality Game Show

Welcome to the Retirement Reality Game Show. Here are the rules: you have 6 months to prepare by storing up all the supplies you need, and then you will be locked in your house for an average of 6 months, during which time additional contests will be played.

Contestant Bob buys up 6 months worth of food and other supplies, and is locked in his house. A jar with 364 black balls and one white ball is prepared. Every day, the game show host pulls out at random one ball. If a black ball is pulled, then Bob stays in his house another day. If the white ball is pulled, then Bob is released from the house.

On average, Bob will stay in the house for 183 days, which is about 6 months. But there's a 50% chance that Bob will stay in the house longer. If Bob plans his meals to last 183 days, there's a 50% chance that the viewers of the show will watch him starve.

Let's look at the graph of the probability that Bob will still be locked in the house on a certain day.
Now let's take another look at the probability of a 65-year-old surviving to a certain age.
The life expectancy graph was previously presented and explained in this post.

Aside from the fact that one graph is a simple straight line and the other is curved, these graphs are similar. If Bob prepares for an average stay in the house, he has a significant chance of starving. If you plan your retirement savings and withdrawals in retirement for an average life expectancy, there is a significant chance that you will run out of money and suffer whatever consequences follow.

While no analogy is perfect, it should put in basic terms the idea that if you prepare for the average, there's a significant chance that you will have under-prepared.

Putting the Personal in Finance

Grace over at GRACEful Retirement had this comment recently about my blog.
EMF at Engineering My Finances tends to be a bit more general and way more math-oriented. I read him, but I don't always understand him!
I have to say that I agree with her, and take it as a reminder that I need to improve my writing skills when communicating some of the complex topics I take on.

Unlike many in the Personal Finance Blog-o-sphere, I never had the situation with a financial meltdown to overcome. I've never had to answer the phone worried that a bill collector was on the other end. I've never had to decide which utility bill I might get by without paying that month.

Does that mean that I always had it easy? Or that I inherited money? No, quite the opposite. Growing up in a large family, I never went hungry. But there were few extras, and my parents struggled to pay bills. I did not live in a house with indoor plumbing or a TV until almost a teenager. When a teenager, I did not have an allowance handed to me. Instead I got small amounts for doing chores, and later on I got jobs. I will say that some of the low skilled jobs I had as a teenager were lower paying yet harder than jobs I had later as an adult.

Then as an adult, I was not provided a free education -- I had to earn it. After 4 years in the military, I had the Vietnam Era GI bill. But with a wife and child, the GI bill did not pay enough to get by, so I had to work full time and did not graduate until in my 30's. But with the GI bill I was able to pay my tuition and buy textbooks as I went along and had no student loan debt.

My experiences growing up taught me the value of money, and impressed upon me that I didn't want to be caught without it. So I've always tried to live reasonably but within my means. My wife didn't agree, wanting to spend freely, and ended up divorcing me. Within a year she had spent the entirety of the divorce settlement. Although I didn't think so at the time, in the long run she did me a favor by divorcing me.

As Grace pointed out, I am math oriented. A few years ago, some friends came into a lump sum and were arguing whether to pay off credit cards or pay ahead on their mortgage. When asked, I gave the logical financial answer that it was better to pay off the credit cards because the interest rate was higher and also not tax-deductible. Being a few years older and having reflected a bit, I would now give the personal answer. Which would be along the lines of "Unless you understand why you have this credit card debt, I would pay down the mortgage. Because if your credit limit or the payments is what's keeping you from charging more, that's the better course. Because in 20 years you won't have anything to show for what you've charged except for the debt -- you'll have none of the crap you charged, but at least your house will be paid for. On the other hand, if you have control of your credit card spending and can pay the credit card bill in full each month, then go ahead and pay them off. Then take the money each month you would have been paying on your credit card bills and apply it to your mortgage." Actually, because it is personal and I'd want to keep them as friends I wouldn't put it quite so bluntly.

So I recognize the need to remember the personal as well as the finance. Even though some of my posts have been and will continue to be more on the side of finance.

Tax Considerations for Investments in Retirement Accounts

Humberto Cruz has an article entitled “After-tax allocation tricky to calculate”. It reminds us of two factors for considering our retirement savings.

First, funds in a before-tax account such as a traditional IRA should be discounted based on your expected taxes when withdrawing them. $100,000 in a traditional 401(k) is not the same as $100,000 in a Roth IRA or even $100,000 in a normal after-tax account. While I expect at least some of my 401(k) savings to be withdrawn at a lower tax rate, I also expect to pay some taxes on it. For current tracking purposes, I discount the value of my 401(k) and traditional IRA accounts by my current marginal tax rate when calculating my net worth.

The second factor to keep in mind is that withdrawals from before-tax accounts are taxed at your ordinary tax rates at the time. Long term gains from stocks do not enjoy the capital gains income tax rate of 5% or 15%.

Read Humberto’s article to see how he handles these two factors.

The Zeroeth Law of Financial Security.

CNN reports that Tony Snow may be stepping down. No this is not turning in to a political blog. From the CNN article:

"I'm not going to be able to go the distance, but that's primarily for financial reasons." Snow said. "I've told people when my money runs out, then I've got to go."

According to The Washington Post, Snow makes $168,000 as the White House spokesman.

$168,000 is more than the income of the vast majority of Americans. Tony Snow-job took a cut in pay from his job at Faux News. And it would appear has not changed his spending habits, so has depleted whatever savings he had which appear from the article to include college money for his kids.

Financial security isn't what you make. At any income level, it's also what you spend. So let me restate it:
The Zeroeth Law of Financial Security "Spend less than you earn."

Why not call it the first law? Even Dave Ramsey doesn't include it in his list of "Baby Steps". It's so elementary that it shouldn't need to be stated. Unfortunately, too many people forget it and end up in trouble. At least Tony Snow has his eye on his situation.

When Will You Die?

Average life expectancy seems to enter into on line discussions on deciding when to collect Social Security benefits, with the goal of maximizing benefits collected during your lifetime. Some comments imply that if you're age X you'll live Y years and die, for instance one commenter stated that a 65-year-old has a 20-year life expectancy implying a certain death age of 85. But I'm sure that if put to them that way, they would tell you that's not what they meant.

I decided to look into it a bit further. On the Social Security Administration's web site, I found a table with life expectancy data calculated by their actuaries. Excel has the capability to import HTML data formatted like the chart. I did so, and with some added calculations, I was able to produce the graph shown below. In case you have difficulty reading the legends, the blue curve shows the probability of an average male aged 65 surviving to a particular future age, and the vertical blue dashed line shows the average life expectancy for that male. The pink curve and dashed line is the equivalent data for a female aged 65. As you might expect, the average life expectancy for a 65-year-old female of 84.2 years is longer than the 81.33 years for a 65-year-old male, almost 3 years longer.

If we look at the curves, a straight line approximation starting from 1 at age 65 and dropping to zero at age 100 would be a reasonable approximation. Certainly not perfect, but a lot closer to the curves than an approximation which has a value of 1 from age 65 and then falls to zero at the average life expectancy. So no, the average person doesn't live to their life expectancy and then fall dead.

This is significant to retirement planning. If you are among the more than 50% who live longer than your average life expectancy and that's the age to which you planned your savings prior to retirement and spending after, then you'll suffer the consequences.

Yes, I said that you have a greater than 50% chance of exceeding your average life expectancy. If you'll look closely at the graph, you'll see the life expectancy lines intersect their curves above the 50% line. For females, the median life expectancy is almost a year longer than the average life expectancy.

With a bit more computation on the data I downloaded to analyze the data for an average 65-year-old, I produced the following graph: Using the same blue-for-boys/pink-for-girls coding scheme, this graph shows the probability that an average 65-year-old will die at a particular one-year span of age. Note that the probability is less than 4.5% at any age, and the highest probability for a one-year span is at greater than average life expectancy.

Meaning that when 65 years old, your chances of dying in a year other than your average life expectancy is greater than 95%. A very high degree of uncertainty when planning your retirement. I plan to discuss this further in a future post.

Means Testing of Social Security Benefits Already in Effect

Jed Pittman on HelpYourMoney has a post entitled "Thoughts on Social Security" which discusses the possibility of means testing for Social Security benefits, and ends that part of the discussion by quoting Ben Stein who said "Those who have saved will be made to pay for those who haven’t ..... "

It just so happens that a mechanism for means testing Social Security benefits is already in place for taxing those who have saved for retirement while not taxing those who haven't.

The way it works is that a test amount is computed based on adding your taxable income (which includes withdrawals from tax-deferred retirement savings) to 1/2 of your Social Security benefit. If the test amount reaches $25,000 for a single person or $32,000 for a married couple, then each additional dollar of income results in taxation of $0.50 of Social Security benefits. At higher test amounts, an additional dollar of income results in $0.85 of Social Security being taxed for each $1 of other income. Specifically when I say that Social Security is taxed, up to 85% of your benefit can be added to your Adjusted Gross Income (AGI). But if your AGI is less than your exemptions and deductions, then it still won't be taxed. Refer to the worksheet for line 20 of the 1040 tax form for details, although the computations are rather mind numbing -- I set up a spreadsheet to do them so I could see how it worked.

The problem is that the $25,000 and $32,000 exclusion amounts in the test computation are not adjusted for inflation.

Let's consider a single person who has not saved for retirement at all and only has income from Social Security. This person has no pension, no portfolio of stocks -- just Social Security. That person would need to have more than $50,000 in Social Security benefits before 1/2 of it exceeds $25,000 and any of his benefit is added to his AGI. Exemption and standard deduction for a single person adds up to almost $10,000 in 2007 for a single person 65 or older. So this year over $80,000 of Social Security benefits would be needed before he would pay any taxes at all. Since the exemption and standard deduction amounts are indexed for inflation, this will increase beyond $80,000 in future years.

An average earner retiring at age 66 would draw somewhere around $16,000 in Social Security benefits. Social Security benefits are adjusted for inflation. Even so, at a modest 3% annual inflation rate it will be decades before he would have to pay taxes.

Let's compare our spendthrift to another average earner retiring at the same time who has saved enough for an initial withdrawal of $24000 from tax deferred savings with annual adjustments for inflation. The test amount for that person would be $32,000 and he would add $3500 of Social Security to his AGI and unless he had lots of deductions would pay taxes on it.

And as our conscientious saver increased his tax-deferred withdrawals for inflation, more and more of his Social Security benefits will be taxed. He's at the level where every $1 of additional taxable income results in taxation of $.50 of Social Security benefits. So instead of being in the 15% tax bracket, he's really in the 1.5 x 15% bracket or 22.5%. And if in the future the 15% bracket becomes 20%, his marginal tax rate is 30%. With more income such that $.85 of Social Security is taxed for each dollar of other taxable income, then his tax rate gets multiplied by 1.85. (Kind of hurts if the taxes were 15% or even 25% when deferred.) At a 3% inflation rate, the rule of 72 says that his tax-deferred withdrawals 24 years from now will be $48,000 and his Social Security benefit $32,000, of which $27,200 or the limit of 85% would be taxed.

And if he thought he could reduce his tax bill in retirement by investing in municipal bonds, guess what! The interest from the bonds is not taxed at the federal level, but the interest is added to the test amount used above to compute how much Social Security is added to his AGI. So he could effectively pay some federal taxes on it anyway. Don't be surprised if in the future Roth distributions are treated similarly.

At the same time, the spendthrift would be a long way from having any Social Security added to his AGI, and because of exemptions and standard deductions which would be inflation adjusted by then to $20,000 it would take even longer before inflation would result in his paying any taxes at all.

When this means-test equivalent was originally put in place, only the very wealthy were effected. With the inexorable march of inflation, more and more Boomers who have saved responsibly will pay more and more taxes. Taxes that will help pay the benefits for the irresponsible who haven't saved.

An Anecdote of the Credit Crunch

A coworker recently bought a new (used) house as part of his plan to downsize now that he's expecting to be an empty nester. But he made the purchase before placing his old house on the market.

Talk about bad timing!!! In the last three weeks he's had no one even come to look at his house. And the local economy is not depressed. Nor is his house in a depressed area.

I suggested that he look at finding a renter. Insurance companies don't like to underwrite empty houses, and he is losing much of his coverage because the house is unoccupied.

A Graphical Look at Delaying Social Security Benefits

In earlier posts here and here, I provided some figures comparing the effect delaying Social Security on future benefits against the monthly return of other options using the amount of delayed benefits. If a picture is worth 1000 words, then here they are. Should the legends in the chart be too difficult to read, here's a recap:
-- The top jagged line is the increase in monthly SS benefits for the amount of benefits delayed. The discontinuities are due to the benefit formulas set up by current Social Security law.
-- The bottom horizontal line is the monthly 4% rule-of-thumb withdrawal on a retirement fund equal to the delayed SS benefits.
-- The three upward sloping lines are inflation adjusted annuities purchased with an amount equal to the delayed SS benefits
----- Top sloping line is the annuity for a male
----- Middle line is the annuity for a female
----- Bottom sloping line is a joint-and-survivor's annuity

The vertical axis is the rate of return. For instance a value of 0.006 is an initial monthly income of $6 for each $1000 of initial payment. All the payment options shown on this chart are adjusted annually for inflation.

Please read the original posts here and here for further explanation.

In my opinion, the 4% rule-of-thumb withdrawal rate should be adjusted for age. But that would be a topic for another post.

Thanks to "J" at Home Finance Freedom for suggesting the graph.

Another Look at Delaying Starting Social Security Benefits One Year

In an earlier post, I compared the added monthly Social Security benefit received for delaying starting your benefits against the monthly annuity payment that could be purchased with the amount of benefits "lost" by waiting. The comparison used inflation-adjusted annuities, since Social Security is also indexed for inflation.

In this post I'll compare delaying Social Security benefits against a withdrawal rate from your own retirement savings based on the 4% rule-of-thumb.

Under the 4% rule-of-thumb for retirement withdrawals, you take out 4% of your savings in the first year you retire. The second year you take out an increased amount based on inflation, and continue to adjust your withdrawals each year after that for inflation. For example, with retirement savings of $250,000, you take out $10,000 the first year and if inflation is 3% you take out $10,300 the second year, $10,609 the third year, and so on.

Let's consider an example of a Boomer born before 1955 with a monthly Social Security benefit of $1000 at his Normal Retirement Age of 66. If he waits one year before starting his Social Security, then his benefit would be 8% higher or $1080/month. During that year's delay, he "gave up" $12,000 of Social Security benefits, but gets an additional $960/year thereafter. During the year of delay, he had to make up the $12,000 by extra withdrawals from his retirement savings. At age 67 when starting Social Security, he recalculates his withdrawals from his retirement savings using the 4% rule-of-thumb and finds that he needs to reduce withdrawals by 4% of the $12,000 or $480/year.

So what's the net change in annual income for our example Boomer from delaying Social Security?
+ $960 from Social Security
- $480 from retirement savings
------
+ $480 net annual increase.

In addition, depending on his taxable income (which include withdrawals from tax-deferred retirement savings), he could find his taxable income reduced by up to $480.

Who loses by his doing this? His heirs, should he die early -- if he died at age 67 then his heirs would inherit $12,000 less. IMO, this should not be a consideration unless your heir is your dependent, such as a special needs child. Otherwise, it's better that you have a secure retirement and not depend on your heirs for support.

In a future post, I'll discuss the 4% rule-of-thumb and my take on it.

How to Use a Windfall?

I received my AARP: The Magazine today. In it was a column of the same title as this post.

The question put to columnist Eric Tyson was: "I'm 54 and just inherited $50,000, which is about what I owe on my mortgage -- the only debt I carry. Like many people, I have some retirement savings but should be saving more. What's the best use of this money?"

Eric replies by asking if he has 3-6 months savings in an emergency fund, and whether he has disability and long term care insurance. As to whether to pay the mortgage Vs investing, Eric took somewhat of a pass and said that it depended on his tolerance for risk.

My personal recommendation would be that the windfall first be used to increase his tax deferred retirement savings (I guessing that "some retirement savings" might be $50,000 or less). IRS limits for 401k contributions in his case are $20,500 this year, including the catch-up amount of $5000 for someone over age 50. And there will be a similar contribution amount next year. Would also recommend he take advantage of Roth IRA savings, if eligible. If not eligible, your income is pretty high, so same on you for such poor savings.

With a mortgage balance of $50K, I'd estimate that it's within about 10 years of being paid off. If not, then a contribution of $5-10K to the mortgage principal could put it within reach. While he may do a bit better in the stock market, he might not. A reduction in expenses when entering retirement is a more secure proposition.

But aside from what to do with the windfall, his retirement savings need to be structured to provide your retirement without depending on windfalls.

If I got a $50K windfall, I wouldn't have the same choices. I've already paid off my mortgage and am more than maximizing tax-advantaged savings. I'd probably put the money into an after-tax index fund at Vanguard.

What would you do with such a windfall?

I'm a Winner!!!!!

I received a sweepstakes mailing. It has a scratch-off panel, from which I uncovered a Royal Flush. This entitled me to the grand prize of a $5000 gift certificate. Being rather skeptical, I noted the tiny asterisk next to the prize description and looked at the fine print.

The prizes and odds are:
--$250 Racing Gift Certificate, Odds 1:121,398
--$500 Gift Certificate, Odds 1:121,398
--$5000 Gift Certificate, Odds 121,396:121,398
Look at that again. The odds of winning either $250 or $500 are almost nil. But the odds of winning $5000 are almost 100%. But it's not in cash, but rather a "gift certificate". And the "gift certificate" is really a coupon good only for a car at the car dealer sending this out, probably with the price jacked up to cover the $5000.

Further, they offer $3781.42 of "Down Payment Assistance". The cynic in me expects that "Down Payment Assistance" means that you are allowed to reduce the size of your down payment and borrow it instead.

I believe that if it's too good to be true, then it's probably not true. I'm not wasting any time going after my "prize", as it would be a booby prize instead. And I will keep this in mind the next time I'm in the market for a car.

Are We Saving Optimally for Retirement?

Scott Burns has written an article entitled "We're Better Off Than We Think" on the subject of how well we're saving for retirement. He points to “Are Americans Saving ‘Optimally’ for Retirement?” which is the results of a study at the University of Wisconsin concluding that we're not so bad off.

However, as pointed out in the article
"Is There Really a Retirement Savings Crisis?" published by the Center for Retirement Research of Boston College, that for Boomers the answer may be "No, we're not saving optimally."

The Wisconsin study sampled people who were in the age range of 51 to 61 in 1992. The youngest of this group was born in 1941, 5 years before the earliest Boomer. There are a number of factors involved which will make it more difficult for Boomers than for the older generation.

Boomers will be increasingly subject to having their Social Security benefits reduced by increasing Medicare premiums. Additionally, Boomers are more likely to have their Social Security benefits taxed since the exclusion thresholds of $25,000 for a single person and $32,000 for a married couple are not indexed for inflation. If other income (including some that is not ordinarily taxable) plus 50% of your Social Security benefits exceed your exclusion level, then some or up to 85% of you Social Security benefits are added to you Adjusted Gross Income and may cause you to pay tax. The seemingly inexorable march of inflation will make it so -- even at a modest 3%/year inflation rate prices will double in 24 years (per the rule-of-72).

The defined benefit pension is going the way of the dodo bird, with more and more companies freezing pensions and/or restricting participation by new hires. A larger percentage of the people sampled by the Wisconsin study have a a pension to help with retirement than will the percentage of Boomers when we retire.

The Federal Reserve's 2004 Survey of Consumer Finances shows that the median net worth of a household in the age range of 55-64 (with retirement imminent) is $248,000. However the median net worth of the vehicles and home of this age range was over $150,000. What will happen to the price of McMansions if a large number of Boomers try to downsize by selling to the smaller Generation X following? (The basic supply Vs demand curve.) But then you have to ask whether the average boomer will want to downsize, or prefer to continue living in the same house. Would you want to sell your house in which your kids grew up and in which you've grown comfortable and move to an efficiency apartment? If you want to stay in your house, its effective net worth is reduced. Even with a reverse mortgage, you will extract only a portion of the equity during your lifetime.

Personally, I think the average Boomer is in trouble when it comes to retirement. I'm doing my best to ensure that I'm not one of them. I suspect that most people really haven't given it much thought, just assuming that a comfortable retirement automatically awaits those reaching the age of 65.

A "No-Spin" Mortgage?

I've heard Ray Vinson on the radio advertising a $72,000 mortgage loan for only $299 a month. In some of Ray's commercials I've heard Bill O'Reilly endorse Ray's "No-Spin Mortgage". Ray goes on to brag about how he's "saved" people hundreds of dollars a month.

I went to Ray's web site to see if he had any details on this wonderful mortgage, but if he had any they were well hidden. I brought out my financial analysis tool, Excel, and calculated that a 30-year fixed rate loan at the terms stated would require that the interest APR would need to be about 2.88%.

I didn't think that interest rates were that low, and at www.bankrate.com found that a 30-year fixed rate mortgage with zero points is running somewhere around 6%, or twice that. Looking around a bit, I saw an ad by Quicken Loans offering $200,000 for $585 a month. While the amounts are different the ratio of loan amount to payment is similar to that for what Ray is touting.

So I clicked on the link in the ad, and was rewarded with an explanation for the wonderful rate. In the fine print for the ad:

Rate is variable and subject to change. After the initial fixed-rate period, the rate will adjust every 6 months. The initial, minimum payment on a 30-year $200,000, 5-year Adjustable Rate Loan and 80% LTV is $583, with 3.25 points due at closing. The minimum payment is based on a rate that is implied solely for the purpose of calculating the minimum payment which in this example is 3.5%. Interest will accrue at a rate of 6.50%. Paying only the minimum payment will result in deferred interest or negative amortization since you will not be paying all of the interest that is owed each month. The unpaid interest is added to principal. Interest can be deferred until the outstanding principal balance is 15% (10% in New York) higher than the original loan amount. If the maximum limit is reached during the first 5 years, the payment automatically converts to an interest only payment. In this example, the maximum limit will be reached in the 53rd month, which is when the loan amount reaches $172,500.00. At this point, the minimum payment will convert to an interest-only payment of $1,245.50. After 5 years, the interest only payment is $1,437.11. After 10 years, the principal and interest payment is $1852.37. The Annual Percentage Rate is 7.533%. Rates could change daily. Actual payments and rates may vary depending on individual client situation and current rates. Some restrictions may apply.

So let me summarize: You're not really "saving" money on this loan. While your cash flow for the first few months after taking out the loan is reduced, you're going deeper in debt as the interest you didn't pay gets added to the loan balance. And when you took out the loan, you immediately went further in debt by $6500 (3.25 points on $200K) plus probably $2K - $3K of closing costs. The example in the fine print is also erroneous or at best confusing. With negative amortization (paying less than the interest) the loan balance will not be $172,500 after 53 months, it will be over $238K. And in reality will probably be higher when the interest rate adjusts above 6.5%.

The devil will be sure to point out all that high-interest-rate credit card debt that was retired when the mortgage was taken out from Quicken. True, you're paying a lower rate on that debt. But you're also paying interest on the $6500 in points you added to the loan, and will be paying interest for another 30 years or so. Perhaps even when you think you'd like to be retired. And if you refinanced from a mortgage that had a lower rate, you're paying a higher interest rate on that amount as well.

Plus, someone who would be suckered in by this deal probably will forget about the forthcoming doubling to tripling of their mortgage payment, and run up the balances on the credit cards, again. When their mortgage payments balloon up, they'll really be in a pickle and this time could find themselves on the street when their house is foreclosed. Learn more about these loans from this Federal Reserve pamphlet or this one.

If you're contemplating such a loan -- don't do it!!! Look for an alternative. Eat Ramen noodles for awhile and pay down the credit cards directly. If it's too late and you already have one of these loans, stop making only the minimum payments. Stop using your credit card and pay them off as quickly as you can. After your credit cards are taken care of, put all the payments against your mortgage so that you finish paying it off sooner. Read more about Dave Ramsey's debt snowball.

If your monthly payments are less than the interest being charged by the mortgage company and the credit card companies, you're not "saving" money. You're getting deeper and deeper in debt.

Is Ray Vinson's mortgage like this? Can't say for sure since he won't tell us. But I sure know which way I'd be betting. I think Bill O'Reilly's "No-Spin Zone" is really "Only-Bill-Gets-to-Spin Zone" but that's off the topic. I'd be interested to hear from someone who's has a mortgage brokered by Ray, either from Vinson Mortgage or from American Equity Mortgage.

In any financial transaction, be sure to find the fine print and read it carefully. And this goes double if you're looking at a "No-Spin" mortgage from Ray Vinson.

Flat Panel Giveaway

Leave a comment at http://www.5minutesformom.com/2032/insignia-37inch-flat-panel-lcd-hdtv-contest/ to enter a giveaway contest for a free flat panel TV from Best Buy.

Your Poor FICO Score can Cost You, Even If Debt Free!

It is discussed in this article on Yahoo Finance that your FICO score can result in increased premiums for auto insurance.

Furthermore, the Supreme Court recently ruled that the insurance companies aren't required to notify you that your poor FICO score has resulted in a higher premium charge.

The Yahoo Finance article goes on to give some standard advice, such as paying your bills on time, and not canceling credit cards that you've held for awhile.

This is all good advice. Additionally, you should obtain your credit scores annually at this site and not the one that advertises on TV as being "FREE". You can get one report from each of the 3 major agencies each year that truly is free. And you can space these reports out every 4 months as I previously discussed so you can more rapidly detect errors. And if you've never checked your credit report, you may find some surprises -- such as incorrect information that can be corrected.

No, your FICO scores are not free. But following good practices and correcting erroneous credit reports can only help your score.

Tracking my Net Worth

Many bloggers publish their net worth figures. I will not be providing figures, but do show the graphic to the side to illustrate my method. The graph tracks my net worth over the last several years and separates it in to categories.

Starting from the bottom of the graph:
-- The blue area is cash and demand deposits.
-- The area above that is government savings bonds, which are almost as liquid as cash.
-- The yellow area represents the value of stocks held outside of retirement accounts.
-- The green area is the value of my titled property (house and vehicles) less any loans (none).
-- The dark red area is the value of my Roth IRAs.
-- The pink area at the top is the value of my tax-deferred retirement accounts, traditional IRAs, 401(k)s, and the cash value of my company pension.

By doing this, I can see liquid assets on the bottom, retirement assets on the top, and property assets in the middle. Or you could view it as short term on the bottom, long term at the top. There is some debate in the personal finance blogosphere as to whether or not the value of your house is really part of your net worth. I think that it is, but its liquidity is low. And if you do sell where are you going to live -- in a tent at a rest area or under a bridge? I think you should have an awareness of the portion of your net worth tied up in your property, but keep it in perspective.

Were I to report figures, they would be lower than what most people would report. Most people would simply add up the market value of their stocks, their 401(k) balances, market value of their house, etc. However, I discount account balances to be more realistic:
-- My government savings bonds are discounted by the taxes on accrued interest, at my current marginal rate.
-- Stock values are discounted by capital gains taxes.
-- My car values are the blue book wholesale value. The value of my house is estimated at 75% of the tax appraisal, to account for real estate commissions, fix up costs, etc, and any error in the tax appraisal (though it is usually about right).
-- My tax deferred savings is discounted as though I had to pay taxes at my current marginal rate. My actual tax rate in retirement may be lower, or contrary to most popular opinion may be higher. But it makes this year's decision as to whether to fund a Roth IRA or tax-deferred savings neutral with respect to tracking net worth.

My method isn't perfect. If it were, I would include the value of my household goods. But why bother? How much would I really get for them at a garage sale?

But in the end, it's like any good net worth tracking scheme. It allows me to get a sense of my progress.

My Guest Post on MoneyNing's Blog

Today, I have a guest post on MoneyNing's blog concerning the bi-weekly mortgage payment scheme. Thanks to David for hosting me.

While some of the content on my blog is of greater interest to boomers looking forward to retirement (or dreading it if they've been a grasshopper instead of an ant), I think that some of my content is of general interest. For example this one on savings rates and compounding.

So please look over my blog, and leave a comment if something interests you. Thanks for stopping by.

I Just Obtained a Free Copy of my Credit Report

I take advantage of the free credit reports available from http://www.annualcreditreport.com/. I do not use the other site that has "free" in its URL instead of "annual" and is advertised on TV. The reason I don't the "freecreditreport" site is that it really isn't free. I regard having to remember to call and cancel and waiting on hold for who-knows-how-long as a cost.

I space my reports among the three major credit reporting companies. I hit Transunion in March, Experian in July, and Equifax in November. This gives me a sample every 4 months of my credit. Since the calendar says that it's July, I pulled my Experian report. As expected, all it has was all both of my credit cards and showed them as being paid current.

The law allowing you to obtain one free copy each year of your credit report from each major credit reporting company has been on the books now for about 3 years. If you have not taken advantage, I highly recommend that you do so. The first time I did, I found errors on all three reports that I was able to have corrected and negatives that I was able to have removed.

With me having paid off my mortgage, owning my cars free and clear, and not carrying credit card debt, and not anticipating being in the market for loans, why should I care about my credit report?

Things could change. I could find myself changing employers and moving to a different city. The prospective employer might pull my credit report to check on my character. Were I to rent an apartment I could have my credit report checked there also. Even if I don't encounter such disruption in my life, my auto insurer bases premiums on my credit report. Were someone to steal my identity, I would find out much sooner than if I waited for the identity thief's charges to work their way to a bill collector.

Delaying starting Social Security Benefits One Year

Scott Burns has an excellent article on his Asset Builder site where he discusses that for him as part of a married couple, delaying the beginning of Social Security benefits will result in an increased monthly payment. And that to buy an equivalent inflation-adjusted joint-and-survivor life annuity on the open market equal to the increase in monthly payment would cost much more than the Social Security benefits he lost during the one-year waiting period.

A little background for those unfamiliar with some of the concepts. Social Security benefits based on your earnings increase the longer you delay the commencement of benefits, up to the age of 70. Someone whose Normal Retirement Age is 66 will receive a monthly benefit that's 8% higher if he waits until the age of 67 to start benefits. Also, Social Security benefits also are increased with inflation. A lifetime annuity is one which is purchased with an initial contribution, and then the annuitant receives a monthly payment for his lifetime. Some annuities are offered with options, such as return of principal, that are not equivalent to Social Security. One option that is equivalent to Social Security is joint-and-survivor life. The annuity can be structured to pay a certain amount to the annuitant, and if he dies then all or a portion will be paid for the lifetime of his survivor (named at the purchase of the annuity). Under Social Security, when one of a married couple dies, the survivor continues to receive the larger of the two Social Security checks (unless the Government Pension Offset provision applies).

Let's consider a married couple, in which the wife has earned a Social Security benefit equal to 50% of her husband's. She can draw a benefit based on her own earnings, when her husband retires they also receive his benefits. If the husband dies, the widow no longer receives her own benefit but continues to receive her husbands. If the wife was a stay-at-home mom and has no benefit based on her own earnings but will also receive spousal benefits of up to 50% of her husband's benefit, depending on her age of retirement. However, spousal benefits can't start until her husband also draws his Social Security. In either of these two cases, the widow's benefit is equivalent to her continuing to draw her own benefits plus 50% of her husband's.

In the table below, I have some figures as to the monthly check from an annuity or Social Security benefits not taken during a waiting period. For example, a value of 0.005 would mean that for an annuity contribution of $100,000 a monthly check of $500 would be paid that would be adjusted upward for inflation. Social Security values are for those whose Normal Retirement Age is 66. Annuity values are obtained from Vanguard's web site, see Scott's site for a link.

Monthly return from annuity principal

Age	SS	Male	Female	Joint
62.00	0.005556	0.004747	0.004320	0.004224
62.92	0.005236	0.004892	0.004439	0.004336
63.00	0.006944	0.004905	0.004450	0.004346
64.00	0.006410	0.005064	0.004580	0.004469
65.00	0.005952	0.005222	0.004710	0.004591
65.92	0.005585	0.005367	0.004830	0.004704
66.00	0.006667	0.005380	0.004840	0.004714
67.00	0.006173	0.005588	0.005014	0.004874
68.00	0.005747	0.005796	0.005187	0.005034
69.00	0.005376	0.006004	0.005361	0.005194
70.00	0.005051	0.006211	0.005534	0.005354

The return for delayed Social Security varies because of the formula used to compute benefits. For example waiting from age 66 to 67 increases benefits by 8%, but waiting from age 69 to 70 increases benefits only 6.45%. This is not actuarially correct since 1 year is a higher portion of your remaining life expectancy the older you get.

As a single male, the spousal aspects of Social Security do not effect me, and there fore my payments under an annuity are 12-15% higher than they would be if I provided a 50% survivor's benefit to a wife of the same age. Therefore, the advantage to me for delaying Social Security is less than for a married man. Even so, I come out ahead up until the age of 68, after which I come out ahead because of the actuarially incorrect computation of Social Security.

For a single female, the advantage for delaying benefits is extended to the age of 69. That's because an annuity payments are lower to a female, not because of male chauvanism but rather because a female has a longer life expectancy.

For a joint-and-survivor annuity with the wife getting 50%, the payments are slightly below that of a single female, so the advantage for delaying benefits also ends at about age 69. This assumes that the wife is exactly the same age as the husband. The payments will be decreased for a younger wife, with greater reductions for a greater difference in ages. Also to be considered is whether the wife has a benefit based on her own earnings that's higher than the spousal benefit. In that case, the survivor's benefit is less than 50% so an annuity payment would be higher than that in the table, and the advantage for delaying benefits decreases.

For a couple with a stay-at-home wife, the advantages for delaying benefits are the same as a single male up until the wife reaches her Normal Retirement Age. After that, any disadvantage quickly disappears because spousal benefits are not increased for waiting beyond Normal Retirement age -- but they are decreased for taking benefits before the Normal Retirement age.

Hopefully this along with Scott Burn's article will provide some food for thought. I urge you to learn more about how your benefits are computed from the Social Security Administration web site, the links on Scott's article, and some study of your own situation. There are other factors to consider, such as whether your Normal Retirement age is close to 65 or to 67.

Should you convert ALL of your retirement savings to Roth?

Recently on The Simple Dollar blog, there was a discussion about future tax rates. Gail posted the comment:
"I am 56 with all my retirement funds in both Roths and traditional IRAs. I am working on a 10 year plan to complete converting all my traditional IRA funds to Roth IRAs by the time I qualify for regular Social Security. Why? Two reasons, neither very complicated. First, regardless of tax rates, I prefer knowing that I won’t have to worry about paying taxes at a time in my life when I may not be able to afford it as easily as I can now. (Same reason why I paid off the mortgage on the house). Second, assuming my investments outperform me, my children will not need to pay taxes on the Roth when they inherit and begin withdrawals.

I believe that Gail's plan to convert all of her tax-deferred retirement savings goes against her goals. While I believe that marginal tax rates will increase in the future, I also believe that there will be a certain amount of Adjusted Gross Income which is not taxed -- your personal exemptions and standard deductions. In 2007, the amount of AGI not taxed is $9800 for a single person 65 or older.

For this discussion, let's assume that Gail's investments do slightly better than the inflation rate. For this discussion, the dollar figures will be in 2007-equivalent dollars. Let's say she has $100,000 in traditional IRAs, and that her marginal tax rate is 15%. If she converts it all to Roth IRA, then it will cost her $15,000 in taxes, leaving her with $85,000. If she follows the 4% rule-of-thumb for withdrawals, then she would withdraw 4% of $85,000 or $3400 of it. And yes, all $3400 of that money would be tax free. In reality, the added taxable income from the conversion likely would put her into the 25% or higher bracket, leaving her with less money, only $3000.

Now let's say we were able to persuade Gail to leave the $100,000 in traditional IRAs. She reaches retirement with $100,000 tax-deferred, pulling out 4% or $4000 the first year. Will she pay any taxes on that amount? At first glance, $4000 is less than the $9800 sum of standard deduction plus personal exemption, so you'd expect that no taxes are due. However, the possibility of part of her Social Security being taxed should be considered. If half of her Social Security benefit + all of her other taxable income exceed $25,000 then she would have to add some of her Social Security to her Adjusted Gross Income (AGI). Let's say that she gets $1500/month or $18000/year in Social Security. Half of that ($9000) added to the $4000 equals $13,000. So none of her Social Security gets added to her AGI, and since her AGI of $4000 is less than $9800, she pays NO TAXES anyway.

But we're not done. While I expect standard deduction and personal exemption values to be indexed for inflation, the $25,000 test amount is not indexed. Let's say that over the next couple of decades, inflation doubles and erodes this to the equivalen of $12,500 in 2007 dollars. In that case, she would have $250 of Social Security added to her AGI, resulting in an AGI of $4250, none of which would be taxed.

Let's say that inflation continues for another decade and erodes the test amount to the equivalent of $6250. In that case, $4950 of Social Security will be added to the $4000 resulting in an AGI of $8950. Still less than $9800, so none of it will be taxed.

So by not converting all of her traditional IRA money to Roth IRA, Gail has extra money ($4000/year instead of $3400 or even less if taxed at greater than 15%). As far as the taxes to the heirs, if she converts the money to Roth IRA -- sure, it won't be taxed. But there will be less of it to not be taxed. Said another way, if she leaves it as tax-deferred savings, her heirs would have to pay taxes but would have more money to start with which to pay the taxes. Will they be better or worse off? Depends on Gail's tax rate now Vs their tax rate when they inherit it.

A more important consideration than optimizing taxes for your heirs is ensuring that you're not a burden on your heirs in the event that you don't die. Keeping some of your retirement savings as tax-deferred (traditional IRA or 401k) is a good strategy to increase money available for spending in retirement and reduce the likely-hood of having to depend on your heirs.

However, if you have too much money in tax-deferred savings, some or all of your Social Security benefits will be taxed. At the initial level, $1 of taxable income can result in $.50 of Social Security being taxed, and with additional income $.85 of Social Security can be taxed for each $1 of other income. This effectively raises a 15% tax rate to either 22.5% or 27.75%, and a 25% tax rate to either 37.5% or 46.25%. Not very attractive if you saved only 15% or 25% in taxes during the year that the funds were deferred. And if marginal tax rates increase, it's even worses.

Because of the taxation of Social Security benefits, I am converting tax-deferred savings to Roth IRAs. But I still intend to keep some amount of retirement savings as tax deferred.

My Credit Score

I was given a year's credit monitoring with Transunion, as a result of some of my personal information having been exposed. As part of that I get my FICO score.

My score is 773 of a possible 850. But several years ago, I had a score over 800. What made it decline? There are no late pays, inquiries, or other negatives. And I pay off my credit card balances every month.

Along with my score, I got the following analysis of how to improve it:

There are not enough accounts in good standing on your credit report. Having credit available to you is a sign that you are able to manage your finances responsibly. Lenders like to see that consumers have a large amount of credit available to them, but not so much that they could spend more than they could afford to pay back. If you currently have multiple accounts open with high balances, try reducing your balances below 35 percent of your limits to improve your score. If you do not have many open accounts, consider opening a new credit account or asking your creditors to increase your limits in order to improve your credit score.

There are not enough bank installment accounts on your credit report. A healthy balance of credit and loan accounts is key to achieving a high credit score. It is important to build a record of responsible credit use over time with different types of accounts. Consider opening a new account to strengthen your credit report and improve your score.

The difference appears to be that when I had the higher FICO score, I also had a mortgage which I have since paid off. Since I then had no debts, my score declined.

I'm not about to buy something on time just to pump up my FICO score. A 773 score puts me ahead of 87% of the population, according to the report, and should be respectable enough to keep from negatively impacting my insurance premiums. I am thinking of getting a third credit card, the EmigrantDirect 1.4% cash back MasterCard to use instead of my DiscoverCard.

How much should you save every year? Let's be realistic.

FMF has a comment on his Free Money Finance blog about the book "The Net Worth Workout:...". That book points out that someone who had invested $1000 annually for 44 years would have retired with $600,000.

I find this ridiculous -- not the numbers which may be mathematically accurate. What I object to is the scenario. There's been a good deal of inflation in 44 years. Forty-four years ago, in 1962, the average wage was $4291, and that's yearly, not monthly. $1000 is more than 23% of a pretax income of $4291. In 1962 $1000 was bit much to expect of someone in their 20's starting a family and probably earning less than this average wage. On the other hand, in 2005 the average wage was $36,952 and $1000 would be less than 3%, hardly an adequate savings rate for someone about to retire.

A more realistic scenario would be someone who invests a fixed percentage of his income, adjusting the contribution to his nest egg as his salary increases. I have a spreadsheet available online that shows that someone who earned the Social Security average wage and invested 10% of his income in stocks beginning in 1962 would have have $754,269 at the end of 2005.

While a more realistic scenario than the one in the book, there are still flaws. One flaw is that earning the Social Security average wage throughout your working career is improbable. More likely it will be lower than the average when you're young and then increase as your career develops.

A major flaw in the spreadsheet is that it does not compute the effect of taxes. The actual value of the nest egg would be less, because a significant part of the S&P 500 return is dividends, which are taxed when paid so less is available to reinvest. There are also the taxes to be paid on unrealized capital gains. While tax-free returns on your investments were not an option in 1962, they are an option today, in a Roth IRA. The contribution limit is high enough that someone earning the average wage can contribute more than 10% of his income. So ignoring the tax aspect is a flaw only in the historical sense.

In the end, however, I agree with the main point of the book and of FMF. You should have more than $44,000 in assets (other than personal property) when you retire. And a steady (but realistic) savings rate should get you there.

Budgeting for mid range goals

As I discussed previously, I budget for retirement savings and also for midrange expenses, leaving the remainder to handle monthly recurring expenses which I don't track in detail.

Midrange expenses that I need to save for are those such as:

• Taxes and Insurance that are billed annually or semiannually
• Major repair items for my house
• Car depreciation

When I had a mortgage, the mortgage company set up an escrow account to handle property tax and insurance premium payments. Every year I would get a statement showing the balance and expected expenses for the following year (based on the prior year). Then it showed the required monthly contribution so that the estimated minimum balance would be several months expenses.

Now that the mortgage has been retired, the taxes unfortunately are not. Without a mortgage I could drop property insurance but choose to keep it in force. To avoid a big impact to my finances when these expenses come due, I set up my own escrow account which I track in my spreadsheet. Since this works well for housing related expenses, I also track tax and insurance payments for my vehicles the same way. Future expenses are based on prior expenses with an inflation adjustment. The spreadsheet can predict balances based on monthly contributions and estimate a low balance. If necessary I adjust my contribution so the lowest estimated balance is still a few months expenses.

And being a property owner, I don't have a landlord to harass when problems arise. I've had to have the roof reshingled and the central furnace / air conditioning replaced in the last few years. I've been setting aside $100 / month to cover these expenses, and when these expenses came up I was able to handle them without going into debt.

Most people have car payments, and then view the cost of driving a certain distance as the cost of the gas they'll burn getting there ignoring the depreciation on the vehicle. Since I've paid for my last two vehicles outright, I view the cost of driving a certain distance as the added depreciation due to driving that distance, which far exceeds the cost of gas even at $3/gallon. So I estimate the cost (other than gas) to drive a mile as the price of a vehicle divided by 100,000 miles. So a $20,000 vehicle is depreciated in my system at 20 cents a mile, to which I add a couple of cents a mile to handle tires and other maintenance items. Every month, I put my odometer reading into my spreadsheet and it computes how much to set aside for depreciation.

Yes, I know that a vehicle depreciates fastest when new whether driven or not, but since I keep my vehicles for several years it averages out. You might also point out that vehicles should last more than 100,000 miles. True perhaps, but the older the vehicle the more often repairs are needed. With my system I should have enough saved to replace the vehicle after having driven it 100,000 miles.

While my method could perhaps use some refinement, it still has served me well. I know how much to keep in more liquid assets to handle these expenses, and can keep retirement savings separate to be kept in longer term investments. I plan to continue this approach even into retirement, but adjusting as a go along if any changes come up, including lifestyle.

The Power of Compounding

This article points out the power of compounding. Someone who saves $100/month for 10 years between the ages of 22 through 32 and then stops saving has more money at the age of 64 than someone who waits until the age of 32 to begin saving at the same rate and saves for 30 years. (Assuming 8% interest).

Not arguing with the math, but rather with the practicality. When I was in my 20's, $100/month would have been a significant hit to my budget, whereas now it's not such a big deal. Not only has my income increased in real terms, but there's been a good deal of inflation since then, including a few years of double-digit inflation.

These articles point out the power of compounding when it comes to savings, but leave out the power of compounding when it comes to inflation. Even at today's more modest inflation rates the compounding can be significant. At 3.5% annual inflation, the value of a dollar is halved in 20 years.

In the example given, the person who saved in his 20's was saving more valuable dollars than the person who waited until his 30's to start.

My point is not against saving, nor is it against saving while at a young age. Rather my points are that (1) effects of inflation can't be ignored and (2) your savings rate should not stay level over long periods of time.

Start young, save what you can, and adjust your savings rate for inflation and improvements in income. And hope that the earnings on your investments keep ahead of the inflation rate.

Mortgage != Debt

Usually I listen to audio books while driving, but as my book was complete I instead listened to the radio while driving to the New Year's Eve party. A commercial came on that began "Start 2007 debt free!!!!", and then went on to pitch a mortgage refinancing scheme to pay off your credit card. Funny -- I always thought a mortgage was a debt. Unless they offer a special kind of mortgage that you don't have to repay.

Unfortunately too many people won't question the commercial. They'll refinance and become "debt free", and then max out their credit cards again.