Posted on April 17th, 2011 William No comments
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.
Posted on February 27th, 2011 William No comments
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.
Posted on January 16th, 2011 William No comments
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:
Car Payment $200
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.
Posted on January 8th, 2011 William No comments
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.
Posted on December 16th, 2010 William No comments
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.
Posted on December 12th, 2010 William No comments
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.
Posted on December 9th, 2010 William No comments
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.
Posted on November 27th, 2010 William No comments
The rules regarding contributions to and disbursements from individual retirement accounts change from year to year based on what Congress does; here's what you need to know for 2010.
If you are under 50 at the end of 2010, you can contribute either $5,000 or your total taxable income for 2010, whichever is less. This limit applies to both traditional and Roth IRAs; you may split the money between them, but the total contribution must be no more than the numbers above. If you are fifty years old or older, the limit is raised to the lesser of $6,000 or your total taxable compensation for 2010, with the same restriction as above.
The income limits for claiming the deduction for contributions to a traditional IRA were raised for 2010, as follows. Note that all numbers refer to the modified adjusted gross income.
If your filing status is single or head of household, you can take the full deduction for contributions to a traditional IRA provided that you made (an adjusted) $56,000 or less; you're entitled to a partial deduction provided your adjusted gross income was less than $66,000. If you are married filing jointly or a qualifying widow(er), those numbers increase to $89,000 and $109,000. However, if you are married filing separately, you're entitled to only a partial deduction and only if your AGI was less than $10,000, unless you did not live with your spouse at any time during the year, in which case the rules for single filers apply.
The above numbers apply if you are covered by a retirement plan at work. If not, and you are single, head of household, a qualifying widow(er), married filing jointly, or married filing separately with a spouse who isn't covered by a plan at work, then you can take the full deduction regardless of your AGI. If your spouse is covered by a plan at work, then your limit is $167k for the full deduction, $177k for a partial deduction if filing jointly, $10k for a partial deduction if filing separately.
For a Roth IRA (which doesn't come with a tax deduction), your AGI may affect how much you can contribute. If you are single, head of household, or married filing separately and you did not live with your spouse at any time during the year, you can contribute up to the limits discussed above provided your modified AGI is less than $105k, and a reduced amount as long as it is under $120k. If you're married filing separately and lived with your spouse at any time during the year, you can contribute a partial amount if you made less than $10k. If you are married filing jointly or a qualifying widow(er), you can contribute the full amount if you make under $167k and a partial amount if you make less than $177k.
Another change for 2010 is the elimination of the filing status requirements for converting a traditional IRA to a Roth IRA, and the provision for extra catch-up contributions for certain employer bankruptcies no longer applies. Additionally, the provision allowing tax-free distributions from IRAs for charity is expiring and is no longer available.
The IRA distribution rules for 2010 state that if you made contributions to an IRA in 2009, you could withdraw them tax free at any time up until your tax return was due (either the original due date or the extended due date, if you filed for an extension); however, you may not take a deduction for the contribution and must withdraw any interest earned on that amount (in case of a loss, the amount of interest may be negative).
You must begin receiving distributions from your IRA by April first of the year after you reach age 70 1/2. However, there is an exception in 2010: if you reached this age last year, you do not have to begin taking disbursements at the normal time, but must take the first one by December 31, 2010.
You may take more than the required minimum, if desired, but this does not reduce the amount that you must take in future years. (The exception is that you can count money withdrawn in the year you turn 70 1/2 against the next year, when you would have your first minimum disbursement). The minimum required distribution varied based on the account balance and can be found by referring to the table provided by the IRS. Failure to withdraw the correct amount or more subjects you to an excise tax.
Posted on November 26th, 2010 William No comments
While this site is primarily aimed at a US audience (and anyone in another country should carefully double check any advice that depends on tax law), it seemed worthwhile to include some information for our friends overseas as well. However, retirement calculations really aren't that complicated: take the amount of money you're going to invest, figure out how long you're going to invest it for, and use a simple formula to determine how much money you'll have at retirement!
The main country-specific item to consider (aside from the differences in available retirement plans) is the Age Pension available in Australia. The age pension provides income for elderly persons who do not make sufficient money to live on; as the numbers will change from year to year, you should refer to the Australian government website for the latest information.
With that in mind, please refer to our other retirement calculators.
Posted on October 29th, 2010 William No comments
How would you like to be a millionaire when you retire? Silly question, right - who wouldn't? But when you think about it, if you're a long way from retirement, you're actually going to need to plan on having quite a bit more than a million dollars, for three reasons. The first is inflation: a million bucks won't be worth anywhere near as much as it is now! The second is longevity; people are living much longer these days (and presumably will be living even longer in the future), so the retirement nest egg needs to last for a long time. The third is quality of life; if you're not working, you'll presumably want to do other things, and doing things generally costs money!
Suppose you decide that you should be able to live well on $100,000 per year in today's dollars, and that you plan to retire in 30 years. At 2% annual inflation, you'll need to receive $181,136 per year at the start of retirement, and that will increase each year thereafter. To reach this goal, you have two choices: you can invest in an annuity or build up a sufficient nest egg to provide for that amount. Let's consider what it will take to reach the former.
Suppose that you're going to invest in stocks returning an average of 10% per year until you retire, and then switch to a more conservative mix returning 5% per year. (Of course, you would really start getting more conservative as you approach retirement, but we'll do it this way to keep the math easy). If you withdraw 4% of your nest egg each year, it will keep growing and you can live off of it indefinitely. So you'll need to save up $181,136 x 25 = $4,528,400 - a bit more than a million! As it happens, you'd need to save about two thousand dollars per month to reach this goal.
That sounds like an awful lot of money, doesn't it? $24,000 per year. Of course, if you only need $50,000 in today's dollars to live on (a more realistic estimate for most people, considering that you should have your house paid off and no debt), then you'll only need half as much money and can do it by saving just one thousand dollars per month. Still a lot, but if you and your spouse are making a combined $60,000 (which is less than the $50k you want after you deduct work expenses), that's 20% of your salary..tough, but hopefully not undoable.