Retirement Savings and Taxes: Protecting Your Assets

One of the major considerations in deciding how to allocate your retirement funds is the tax treatment each retirement vehicle receives. Which tax treatment is best for you depends on a number of factors, but it basically boils down to one question: is it more important to not be taxed now, or to not be taxed later?

Tax-advantaged retirement plans generally fall into one of two categories. Either you are allowed to invest with pre-tax dollars, or you don’t pay taxes on the earnings. Let’s take a look at the advantages of each.

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Remortgages

Remortgaging is similar to refinancing, and the two terms are often confused; it is effectively the transfer of your mortgage from one lender to another. The term remortgaging is mostly used in the UK; elsewhere it is primarily known as switching. The term applies only when the homeowner is switching to a different lender, not when switching to a different product with the same lender. The new lender pays off the existing mortgage, leaving the borrower with a new mortgage (hopefully at a lower rate).

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How Facebook Makes Money

If you’ve seen The Social Network (which is entertaining, if somewhat fictionalized), then you’ll know that Mark Zuckerberg originally was strongly opposed to putting ads on Facebook. If you’ve used Facebook lately, you’ll also know that that this is no longer the case – Facebook now serves up quite a few ads. So is advertising how Facebook makes money?

Ads, ads, ads

In a word…mostly. While ads don’t make up all of Facebook’s revenue, they’re definitely responsible for the lion’s share. In 2008, Facebook sold $300 million in advertising; that increased to $500 million in 2009 and more than tripled to $1.86 billion in 2010, of which 60 percent came from small companies. $740 million came from well-known brands including Coke, Proctor & Gamble, AT&T, and Match.com.

While Facebook still lags behind Google, they have the advantage of offering very precise targeting. Users (well over half a billion of them) share a lot of information on Facebook: age, location, relationship status, sexual preference, education, employment, interests, religious views, political views, favorite music, favorite books… you get the idea. As a result, advertisers can now put their ads in front of the people most likely to be interested in them, making them more cost-effective. (As one example, my current employer is running Facebook ads to hire more people…a fact I’m aware of only because I fit the profile to see them!)

Of course, Facebook ads don’t have particularly high clickthrough rates – people who use social media sites tend to be more tech-savvy than most, and either use an ad blocker or just ignore the advertising, resulting in an average clickthrough rate of only about a twentieth of a percent – but when you’re serving a couple of billion ads per day, it still adds up pretty quickly!

However, advertising doesn’t tell the whole story. How else does Facebook make money?

Facebook Gifts

We’ve all seen the notices – your friend’s birthday is this week! Send a virtual gift for only a dollar!  The Facebook gift shop is gone now – which surprised a number of people, considering that it brought in around $75 million in 2009 -but there are still a number of third party apps that offer similar functionality, and of course Facebook takes a cut. Like Apple’s app store, 99 cents apiece for virtual items adds up really fast when people are buying millions of them! Of course, even before Facebook, there was a thriving business in virtual items as people sold in-game goodies on Ebay. Which brings us to..

Credits

The big new thing for Facebook these days is their virtual currency, which you can use to buy things inside games and other apps. Want to level up faster in that game, or maybe buy a shiny new trinket that’s just fancier than the free one? Facebook will take 30% of that purchase. By promoting credits, of course, they encourage you to spend even more time on the site (after all, you now have money invested in the games, as well as time), which means you’ll see even more advertising and be tempted to join in on even more activities that require credits.

If You Built It, They Will Come

At heart, Facebook’s strategy is simple: build an addictive social platform, get tons of users, and then figure out how to monetize it. At the start, the gimmick was exclusivity: only students at particular universities were allowed in. Now, with the service open to everyone over 13, the main reason to join Facebook is simple: it’s where all your friends are. Facebook, then, needs to ensure that this continues to be true – that their platform remains the easiest way to stay connected with the majority of the people you know. As long as they can do that, the money will follow.

Bad Idea #1: Cashing Out a 401(k) to Pay Off Debt

These days, a lot of people are working to pay down debt, which is a great idea; few things are more stressful than owing money, so paying off your debts not only helps you to have a better retirement, it can have positive benefits on your health right now.

Still, that doesn’t mean that paying down debt is always the best option. One particularly bad idea is to cash out a 401(k) plan to pay off your debt.

Why is that a bad idea? Here are the three biggest reasons:

1) The money is supposed to be for retirement! If you pull it out now, it may look like a smart move – after all, you’re probably paying more interest on your credit card than you’re making on your retirement plan – but it’s a lot easier to ignore your retirement account being too small than your debt being too big (at least until you get close to retirement!) You should make a practice of never touching your retirement funds if it’s at all possible; once the money is in there, it’s off limits.

2) The government will even help enforce that practice; if you haven’t reached retirement age and you try to take money out of your retirement account, you’re going to face some hefty penalties and interest (with the exception of principle on a Roth IRA, of course). Just by taking the money out of your account, you could end up losing a third of it immediately, before it even has a chance to do you any good.

3) Retirement funds (up to a certain limit) are exempt from bankruptcy. If your debt gets the better of you and you’re forced to declare bankruptcy, you can shed the debt and keep the retirement funds. As such, even when things feel hopeless, it’s still best to leave the money in your 401(k) alone if at all possible.

Of course, sometimes there really is an emergency – most likely medical – that completely justifies pulling the money out; in this case, you may even be able to avoid the early withdrawal penalties. However, consider your options carefully; not having adequate retirement savings is always a bad idea!

What is the maximum 401k contribution per year?

You’ve probably heard that you should max out your retirement contributions each year, if you’re financially able to do so. Aside from the obvious reasons – a little saved now can be worth more than a lot saved later – the government puts a limit on how much money you can put into a retirement account each year. The maximum amount generally increases each year, so even if you put aside the maximum last year, it’s worth checking to see if you can increase your savings.

Notice that I said generally, not always…and as it happens, the maximum 401k contribution has stayed the same in 2011 as it was in 2009 and 2010. If you are under age 50, you can contribute a maximum of $16,500 to a 401(k), 403(b), or 457 plan; if you are 50 or over, you can put in an additional $5,500 (for a total of $22,000). Note that you may have multiple plans (for example, a traditional and a Roth 401k) but the combined contributions cannot exceed these limits. Additionally, you cannot contribute more money to a retirement plan than you actually earn!

In addition to the amount you put in, your employer is permitted to contribute to your account as well; this contribution (generally in the form of matching funds, such as a 50% match on your savings) must be made with pretax dollars regardless of whether you have a traditional or a Roth account. The employer contribution can be up to 25% of the employee’s pretax earnings, up to a total of $32,500. This means that the combined contribution (employee + employer) can reach a total of up to $49,000 (more if you’re over 50).

Maxed out your 401(k)? Not to worry – you still have IRA contributions to make! IRAs and 401k plans are completely separate; maxing out one doesn’t affect your ability to contribute to the other. However, the IRA contribution limits are much lower: $5,000 per year, or $6,000 if you’re 50 or older. As with the 401(k), you can divide your contributions between multiple IRAs, which may be traditional, Roth, or a combination, but the total contribution must be no more than $5,000 (or $6,000) per year.

Do note that if you make a lot of money, you may not be eligible for certain types of retirement accounts; once your income reaches six figures, you’ll want to consult with a tax professional.

Are Prosper Loans a Scam?

An interesting trend in finance these days is the rise of peer to peer lending, in which borrowers get a loan from individual investors rather than from a bank. In theory, everybody wins: borrowers get a loan at a lower rate than the bank would offer (or get a loan that the bank wouldn’t offer at all), investors make a higher rate of return than they would otherwise, and of course, the facilitator takes a cut. These sites have been around for years – I originally joined prosper.com, perhaps the most prominent, over four years ago – but have been in the news lately, and have been featured in the Wall Street Journal.

So are Prosper loans a scam, and if not, how do they work?

At the time that I joined, Prosper loans were funded through an auction format. As a lender, you would find a loan that you were interested in funding, then bid both the maximum amount you would lend and the minimum interest rate that you would accept. Interest rates started at the buyer’s maximum; once the loan was fully funded, lenders would automatically compete against each other in a sort of reverse Ebay, such that the entire loan was funded at the lowest interest rate that would still bring in sufficient funds.

In order to get funding, borrowers generally needed to write a detailed post explaining why they needed the money and how they intended to pay it off; Prosper also did a credit check and ranked borrowers on their creditworthiness. Many people participated on the site as both borrowers and lenders, taking advantage of their good credit ratings to borrow money and then lending it out again at higher rates.

So how well did it work? Well, I invested $1,000 into the site in 2007, in half a dozen loans. At the time, all loans were for a three year period. I reinvested the payments for my loans (which had an average interest rate of around 15%) back into the site, so pretty soon I’d lent out quite a bit more than my initial investment.

Unfortunately, this was in 2007, and towards the end of that year, the US economy fell into a recession and people started defaulting on their loans. By the time I pulled all my money out, half of my loans had defaulted and I got back only about $750 of that original $1000.

So are Prosper loans a scam? I’d say no; the site seems to work as promised, and I got my money back right away whenever I cashed out. I lost money, but I also knew and accepted the risks involved, and until the start of the recession I had no loans in default. If a loan isn’t paid back, the company turns it over to a private collector, but the percentage successfully collected tends to be low.

Prosper itself is still around, but with a slightly modified business model; the company was rumored to be facing bankruptcy last year, but obtained more capital and resumed lending. They now claim over a million members and nearly a quarter billion dollars in loans.

Do I recommend the site? It’s hard to say. A lot of people are here because they can’t get credit elsewhere, and sometimes that’s for good reason. Some people might like knowing that they’re providing credit to those who otherwise wouldn’t be able to get it; however, you can also get that from microlending sites such as Kiva that are strictly charitable (they return your money, assuming it’s repaid – which the microloans almost always are – but without interest). Prosper, on the other hand, has a significantly higher loss ratio than traditional banks. Still, it provides a nice way to diversify, and the site claims actual returns averaging 10.4%. I wouldn’t put a huge amount of money into it, but if nothing else, it can be an interesting place to stash a small part of your portfolio.

IRA Early Withdrawal Penalty Exceptions

While everybody knows they should be contributing as much money as possible to their retirement accounts, the problem is that once you put the money in, you often can’t withdraw it without a penalty. This is by design, of course; the whole point is to force you to leave the money alone until retirement. That said, sometimes you end up in a desperate situation and your retirement account is the only place you can get the money you need. Under what circumstances can you take out some or all of your money, while still avoiding the penalty for early withdrawals?

Fortunately, there are hardship withdrawal exceptions available, but before we get into that, let’s look at when you normally can and can’t withdraw money from your accounts, and at what penalty.

Generally, if you contributed to an account using pretax dollars, you can not withdraw without a penalty. If you want to take money out of a traditional IRA, for example, then you have to pay taxes on any money you withdraw (which would have happened whenever you took the money out in any case), plus you owe an additional 10% penalty.

Normally, the early withdrawal penalty no longer applies once you reach age 59 1/2; at that point, you may withdraw as much money from your IRA as you want, and are required to take a minimum disbursement each year. However, the IRS also recognizes several special cases where you may withdraw money early without penalty; note that you do still need to pay tax on the withdrawals. Also, if you withdraw money during the same year that you contributed it (or rather, before the due date for filing your tax return for that year) then the penalty does not apply.

The first two are for medical reasons. If you lost your job and received unemployment benefits, then you may be able to withdraw enough money from your IRA to cover the cost of paying for medical insurance during the period of unemployment. Regardless of your employment situation, if your medical expenses are over 7.5% of your adjusted gross income, you can take a penalty-free withdrawal without paying the penalty.

If you become disabled such that you are no longer able to work, then your withdrawals are not subject to penalty; additionally, if you die before reaching age 59 1/2, then your estate can collect the money from the IRA without penalty.

Finally, you can use up to $10,000 from the IRA to buy your first home, and can also withdraw as much as you need to pay for college or to roll over into another qualifying plan. If you know you’re going to need to take money out of your IRA in the future, but not immediately, you might be able to do a rollover into an annuity that will begin paying out before you need the money. The IRS actually provides a way for you to do this directly, without bothering with the rollover: you can “annuitize” the account and begin taking withdrawals immediately. The catch is that the amount you can withdraw is based on your life expectancy, and you must withdraw the same amount every year for five years or until you reach age 59 1/2, whichever is longer.

If you only need the money for a brief period of time, IRS rules do allow you to take a 60-day loan from your IRA without paying taxes or penalties, provided the funds are returned within that 60 day period. You can only take one such loan in any twelve month period.

A SIMPLE IRA files the same rules as the traditional IRA, but if you take the withdrawal in the first two years of participating in a SIMPLE plan, the tax penalty (if it applies) will be 25% rather than 10%.

In the case of a Roth IRA, you are allowed to remove any contributions you’ve made, as these are made with after-tax dollars; however, the penalty will apply if you remove any of the earnings, which have not yet been taxed. As with the traditional IRA, there are exceptions if you die, become disabled, or purchase your first home.

Budget Planning: How to Budget

For many people, a budget is a strange and terrifying thing. They fear that a budget will suck all the fun out of life, telling them what they can spend money on and when, and will lead to nothing but family fights.

However, if done properly, a budget is actually a key tool on the path to financial freedom. Rather than being a constricting document, it frees you from worrying about what you can afford and how much money you’re going to have left each month. You no longer have to worry about whether you’ll have sufficient funds remaining to pay your bills, because every dollar is allocated before the beginning of the month.

This doesn’t mean removing all spontaneity and just for fun spending; it just means that you factor it in. For example, suppose that your after tax salary is $2000 per month. (We’ll assume this is also after contributing enough to your 401(k), if available, to get the maximum amount of matching funds). Your budget might look something like this:

Rent $800
Utilities $250
Insurance: $150
Car Payment $200
Savings $250
Gas: $50
Food: $200
Blow: $100

As you can see, a budget doesn’t have to be particularly complicated. You have each area scheduled, including “blow”, which is money that you can spend on anything you want, whenever you want, without feeling guilty. Want to go to a movie or pick up a new video game? You can – you’ve budgeted for it!

Notice that savings are part of your budget; this is very important, as money that isn’t budgeted will, almost inevitably, end up getting spent by the end of the month! When you first start using a budget, your savings should probably go towards an emergency fund so that you have cash available if you need it; once that fund is built up ($1000 is a good number), it can go towards paying off debt instead. For the most part, paying down debt is the same as saving (and pays a better interest rate to boot!) but you want to make sure you have some money available for emergencies.

Of course, budgeting can be slightly more complicated when more than one person is involved, as you’re likely to have some disagreements on exactly what should be cut if you need to reduce some of your spending, but that’s still a lot better than not having a budget and not knowing where your money is going! Start by making a list of all of your current spending, classify it, and then talk about whether you need to cut down on spending and by how much. This doesn’t have to be painful; for example, if you spend too much on eating out, you could change that by learning to cook together. The important thing here is to track all of your spending for at least a month so that you have an accurate idea of how much is actually being spent on each activity; to improve something, you first need to measure it.

How Much is My Car Tax?

When buying a new (or used) car, it may be worthwhile to look at how much you’ll have to pay in taxes. In some states, this could make a significant difference in the overall cost of ownership of the car.

Suppose, for example, that I want to buy a new 2011 Toyota Camry. How much is road tax for my car? The answer is, it depends on the state. Some states, but not all, charge sales tax on cars, so that new Camry could have a couple thousand dollars in sales tax added on, increasing the price difference compared to an older car that’s had time to depreciate.

You also will need to pay registration and title fees; these are technically not a tax, but it works out the same way. Every year, you’ll have to renew your tags; you send the government a check and they send you a new sticker to put on your license plate. The cost of the renewal again varies widely by state; generally it depends on the value of the car. The rules for how much things cost often depend on the weight of the vehicle as well.

Still want to know what the tax will be for a new car? The rate is set by the state legislature and is subject to change, so go to your state’s website – they should have that information available.

Hardship Withdrawal From IRA

With a 401(k), you are limited in when you can withdraw money, but there are exceptions that allow withdrawals due to hardship. With an IRA, there are generally no limits on when you can take a distribution, so there is no provision for an IRA hardship withdrawal.

However, there are certain expenses that allow you to take early distributions without paying any extra taxes; specifically, you do not have to pay the early distribution tax if you withdraw money from an IRA to fund higher education or to finance the purchase of your first home (up to $10,000). (Sections 72(t)(2)(E),(F)) of the tax code). You can also make a withdrawal without penalty if you will use the money to pay for unreimbursed medical expenses (but only if they exceed 7.5% of your adjust gross income), to pay the premiums on your medical insurance if you have received unemployment benefits for more than 12 weeks, or to pay back taxes after the IRA places a levy against the IRA.

Remember that with a Roth IRA, you are free to withdraw your money at any time and for any reason, with no justification required; while this is generally a bad idea (as you likely won’t be able to replace the money, and may owe a penalty if you touch the earnings or any deductible contributions), it does mean that the money is available in an emergency.

Return on Invested Capital (ROIC)

Return on invested capital, or ROIC, is used to measure the historical performance of a company. It is a lagging indicator, which means that it gives information on how a company has performed in the past rather than how it will perform in the future; however, it is not as easy to manipulate as many leading indicators such as discounted cash flow.

ROIC can be calculated simply as net income after taxes (that is, after tax earnings), divided by invested capital. A high number indicates that the company is using its invested capital efficiently, which suggests that it is likely to continue to grow. However, this is by no means a fullproof measure; for example, it is possible that the return came from one-time events rather than ongoing operations.

401(k) with ETFs: Good Combination or Bad Idea?

You may or may not be familiar with ETFs, or exchange-traded funds. ETFs are similar to stocks, and are actually traded on stock exchanges. An ETF is basically a basket that holds a collection of assets for you to invest in, such as stocks, bonds, and commodities. The price of the ETF is approximately the same as the value of its assets. Many investors find ETFs attractive because they are not actively managed and thus have lower costs than other investment products. They also tend to have fairly low capital gains, making them efficient for taxation purposes.

The question is, should you be holding ETFs in your retirement plans? At the start of 2010, about $4 billion in 401(k) assets was in the form of ETFs, so a lot of people seem to think so.

The extremely low expense ratios offered by exchange traded funds can definitely make them an attractive choice; lowering fees can dramatically impact your return on investment over the long run. They also allow you to diversify without the hassle of choosing stocks or funds yourself.

However, ETFs are often used for timing the market, which is at odds with the buy and hold strategy appropriate for retirement funds. Additionally, because 401(k) and IRA plans are already tax-advantaged, the tax benefits of an ETC don’t apply.

So should you use an ETF in your 401(k)? As with many financial questions, the answer is: it depends. If you want to actively manage your portfolio – for example, investing in commodities without the hassle of taking possession, or making sure that you don’t have multiple holdings that are invested in the same company – ETFs can give you the control you seek. If you tend to be a hands-off investor, however, the standard mutual funds offered by your company’s plan may be just fine for you.