October 2010

The Millionaire Next Door by Thomas J. Stanley & William D. Danko is an older book, published in 1996. Even so, it has great insight into the financial lives of many American millionaires. What the book describes may surprise people about how the “average” millionaire behaves.


The Millionaire Next Door describes some of the details of the lives of millionaires, from economic background and careers to what kind of cars they drive and how they buy them. The book compares actual millionaires to non-millionaires who often live the high consumption lifestyle some might expect millionaires to live. It also talks about how much time millionaires spend working on their finances, which illustrates that being financially successful requires work.


While we wouldn’t say The Millionaire Next Door is very exciting (we’ve been told by others that it can be hard to get through), it definitely contains valuable information about how successful people got to be where they are, ideas that you could do well implementing in your own life.


Last week, we talked about the importance of setting financial goals, one of which is often retirement. If retirement is a goal important to you (which we find hard to believe it wouldn’t be!), one of the most important things you can do is contribute to retirement accounts. There are a lot of options for this, but there is one in particular we want to talk about today.


Employer Matched Defined-Contribution Plans

If you are lucky enough to work for an employer that offers a matched defined-contribution plan such as a 401(K) or 403(B), you should be thankful! Participating in this type of plan results in free money to you, and who doesn’t love that? Not everyone has this option through their work, and if you do and aren’t taking advantage of it, you should do so right away.


In employer matched defined-contribution plans, your employer will contribute money into your personal account for your own future use, usually matching up to a certain percentage of your earnings. You won’t have to pay tax on this money until you withdraw it from the account. Our advice is if you have access to this type of plan, make sure you contribute enough of your pay to maximize the amount your employer will put in.


If you don’t know if your employer offers a matched plan, or if you know they do and aren’t taking advantage of it, talk to the plan administrator. Like we said, it’s free money to you, not part of your normal wages, which you need to participate in the plan to get. And it often isn’t a negligible amount either, it could be thousands of dollars a year extra.


There are a lot of excuses as to why people don’t participate in these types of plans. A common one is that someone can’t afford it. Granted, getting the maximum match means that you have to have dollars taken from your wages before you get your paycheck, so yes, you’ll have less take home pay, but you’ll also be paying less in taxes (your contributions are pre-tax so the dollars are not included in your taxable income). You’ll also be making a big impact on your future by accepting money from your employer outside of your wages. So, if your excuse is you can’t afford it, we would suggest taking a serious look at your expenses and make sure you can afford it, even if it means cutting back elsewhere.


If you have the opportunity to participate in this type of plan and aren’t, or if you aren’t maxing out the employer contribution, you should really do so immediately. There is only upside with this type of plan and you can’t afford not participating.

In order to have a good financial life, you must know what you are working towards. People who move aimlessly through their financial lives with no clear goals or plans won’t be very likely to have a comfortable financial situation.


Setting Your Goal

There are unlimited possibilities when it comes to setting your financial goals. And no two people will have exactly the same goals. It’s a matter of personal values. What’s important to you may not be to someone else.


Just think about what is really important to you. Your family? Your goal may be paying for your kids’ college. Your home? Your goal may be renovating your current home. Your career? Your goal may be going back to school yourself. Your retirement? Your goal may be to max out your retirement plan funding.


There really isn’t any right or wrong answer here. We would suggest listing all the financial goals you currently have (don’t start saving for your kids’ college before you have one!). Once you have all your current goals written, select the 2-3 most important ones. Those are the ones you should concentrate on first. Also, be sure you know why it’s important to you that you achieve a goal. If you ask yourself that question and can’t come up with a clear answer, maybe it shouldn’t be on the list.


There may be some situations where you want to concentrate on one goal before the others. You have debt you want to pay down to free up cash flow, and then you plan on using that extra cash on another goal. Work it out however you feel comfortable with; just don’t sacrifice something that needs to be funded (like retirement).


When you prioritize your goals, it shouldn’t necessarily be by the date you want it completed by. People often want to save for their kids’ education and their own retirement, so they will focus on college funding because it will come to pass first, when in reality the more important of the two goals is retirement. Between a choice of having your kids’ college paid for or having to have their support for 30-40 years in your retirement, which one would you choose (and which would your kids prefer)?



Having “financial independence” in retirement is a goal we often see people set. This usually means not having to rely on any one but yourself for your financial needs, typically with no debt and enough savings/investments to take care of all your needs. It’s a great goal to have, probably one that many people should have, and it’s never to soon to start on it.


If you’re 22, just out of college, with nothing to your name, you probably have big goals in mind, which is great! But don’t forget about the future, even if retirement seems so far away. Start funding a retirement account right away, as much as you can, and it will make a huge impact on your financial situation down the road.


Moving Forward

Once you decide what your most important goals are, you have to decide what to do about them. It probably won’t be easy, and may require cutting back elsewhere. If you’re saving for something, you’ll need to decide how much it’s likely to cost and when you want it to happen by, and save accordingly. That may seem simplistic, but once you have decided exactly what you want and even have it written down somewhere, it’ll be much easier to move forward.


Last week, we talked about Roth IRAs and why they are good investment vehicles. Today, we’ll talk about Roth IRA conversions.


The biggest issue in a Roth IRA conversion is tax. Since traditional IRAs are usually funded with tax deductible contributions, when you distribute the money from the IRA, you will owe income tax on it. The same goes for conversions. Since you are converting those funds into an after-tax Roth IRA, you must pay income tax on the amount you convert. This is a consideration that must be carefully reviewed before you decide to make any conversions.


Who Shouldn’t Convert

If you are in the following situations, converting your traditional IRA to a Roth IRA probably isn’t a good option for you.


  • If you don’t have enough cash on hand to pay the tax – There are two options for paying the tax on a 2010 Roth IRA conversion: pay 100% of whatever tax you owe in 2010, or pay half in 2011 and half in 2012. Splitting the tax over the next two years will help to alleviate some of the pain of parting with your money, but if for any reason you don’t believe you will have enough cash to cover the taxes, don’t make the conversion. In other words, if the only way you’ll be able to pay the tax is by withdrawing the funds from the portfolio, it’s not worth doing.


  • If converting pushes you into a higher tax bracket – If $15,000 of additional income will take you into the next highest tax bracket, and you are thinking about converting a $20,000 IRA, you’ll be paying additional dollars in taxes due to the higher rate. However, if conversion fits your needs, you can convert part this year and part next year to avoid paying at a higher tax rate.


  • If you know your tax bracket will decrease – If you want to convert, but expect a decrease in income over the next few years, that will bring you into a lower tax bracket, it probably makes sense to wait. That way you can still convert the money and pay less in taxes.


  • If you plan on leaving the funds to a charity – If you plan on leaving your IRA to a charity after your death, you should leave the money in a traditional IRA. The charity will receive the money from the IRA tax-free, so it doesn’t make sense for you to convert to a Roth.


People who should consider converting

Here are some situations where conversion to a Roth IRA might make sense.


  • If your tax bracket will be increasing – As the opposite to the tax bracket point above, if you are expecting to be in a higher tax bracket in the future and are interested in converting, you should do it now to avoid paying more tax (if you can currently afford the tax and it doesn’t push you into a higher tax bracket!).


  • If you don’t need the Required Minimum Distributions (RMD) – If you don’t anticipate needing to take the RMD from your traditional IRA account at age 70½ for income purposes, converting to a Roth may be a good move. You can protect your account balance by letting it grow undisturbed by yearly RMDs, and you will still have access to the money should the need arise, but you’ll get it tax-free!


  • If you plan on your IRA being inheritance for your heirs – A Roth IRA will provide a better inheritance vehicle because your heirs will receive the money income tax free. If you are thinking about your IRA as more of an estate planning tool, another consideration should be what tax bracket your heirs will be in. If they will be in a higher tax bracket than you when they inherit an IRA, they will be paying income tax on the distributions. You may want to consider converting to pay the taxes now so your heirs can have an income tax-free inheritance.


We just want to emphasize again that the tax consequences of a Roth IRA conversion should be carefully considered before making a move. If you have questions or need help figuring out the taxes on a conversion, talk to a tax professional.

Roth IRA conversion has been a major buzz phrase this year. That’s because starting in 2010, the usual $100,000 income limitation for converting all or part of your traditional IRA to a Roth IRA goes away. With no income limitation on this type of conversion, everyone is talking about who should or shouldn’t convert and why.

We wanted to spend a couple of weeks going over these questions. First, we want to talk about what a Roth IRA is and why it’s worth using at all.

The Value of a Roth IRA

Roth IRAs are retirement accounts that have a couple of major differences from a traditional IRA. Those differences are tax-free growth and withdrawals (for qualified distributions) and no required minimum distributions (RMD) at age 70½.

Retirements plans such as 401(K)s and 403(B)s are funded with pre-tax dollars and traditional IRAs have tax-deductible contributions. Since taxes have not been paid on these dollars, distributions from these retirement accounts are taxed as ordinary income. However, Roth IRAs are funded with after-tax dollars, so you do not pay income tax on qualifying distributions because you have already paid tax on those funds. Because of this, you will never pay tax for withdrawing your original contribution dollars regardless of the situation. However, if you withdraw money from the account that isn’t part of the original contributions (such as gains) in a non-qualifying distribution, the dollars may be subject to tax and penalty, so be sure to understand the rules on Roth IRA distributions before you pull any money out.

Some examples of qualifying distributions are distributions for a first home purchase, the account owner becoming disabled, or the death of the account owner (beneficiaries can pull dollars out tax-free).

Another major difference is that you don’t have to take an RMD at the age of 70½ out of a Roth as you would a traditional IRA. Traditional IRAs start RMD at 70½ and must be taken every year regardless of need. This can have a major impact on the future of your account balance, especially in down markets. If you are forced to take distributions out of your IRA in a down market, your account balance will erode much more quickly than in an up market. With Roth IRAs, you can choose to withdraw money if you need to, but you aren’t required to.

If at your death, your spouse inherits the Roth IRA, no RMD needs to be taken. However, when your kids inherit the Roth, RMDs will be required, but the distributions will remain tax free for them, as opposed to them inheriting a traditional IRA where they will have to pay income tax on the withdrawals.


There are drawbacks to a Roth IRA as well. You need to have earned income in order to contribute (for married couples only one spouse needs to have earned income for both to contribute). Also, there are income limitations on contributions (for 2010, Modified Adjusted Gross Income begins contributions phase out at $166,000 and the limit is $176,000 for married filing jointly, and contributions phase out begins a $105,000 and the limits is $120,000 for single). This rule obviously hampers high income earners from taking advantage of a Roth IRA (though, as with many tax laws, there is a loophole using conversion which we won’t get into).

All told, the Roth IRA is an excellent investment tool for saving for retirement. It’s also a great estate planning tool, allowing for you to pass tax free inheritance to your heirs. However, as good as the Roth IRA is as an investment choice, it’s not right for everyone and converting from a traditional IRA to a Roth IRA also may not be the right choice for everyone. Next week we’ll discuss the question of who should and shouldn’t convert.