Saving in triplicate

Q:  I have been a member of USAA since 1998.  I have a question on savings.  I deployed and during my deployment I paid off all bills and started saving money.  I have that in a money market and an emergency account with $500.  I know the rule is to have six to eight months of emergency funds.  Should I keep those accounts separate and build up the emergency funds and continue to put money in the money market?  I currently contribute the maximum to my Roth IRA.  Should I just rely on my Roth when I retire?

--Michele

A:  Talk about turning lemons into lemonade!  Good job using your deployment to your financial advantage.  First, your emergency fund should be a separate account to make it less easy (or tempting) to dip into.  And, yes, a money market or similar cash account works just fine.  I actually recommend adding to the emergency fund each month, even after you have the full six months worth of expenses socked away.  That way it automatically “refills” if you need to use it. 

Regarding your Roth IRA, please accept another well-deserved pat on the back!  It’s great that you are maxing out your Roth with $5,000 (2009 limit is $5,000).  However, your Roth IRA alone is probably not going to be enough to fund your retirement.  Once you get your emergency fund in ship shape and up to at least 3 months of living expenses, I would encourage you to supplement your Roth savings in two additional ways.  The first is contributing to the Thrift Savings Plan (TSP).  The TSP is just the opposite of the Roth in terms of taxes:  you save tax money currently and commit to paying taxes in the future during retirement.  Second, I recommend you invest for the long term in mutual fund accounts outside of the TSP and the Roth.  When you liquidate those funds down the road, your investment gains will be subject to long term capital gains tax which is capped at 15% currently (if the investment is held for a year or more).  The result of combining those three strategies achieves tax diversification which will allow for having some control over taxes in retirement.  

 

I know I don’t sound like much fun! Save in triplicate. But you seem like an effective financial manager, so you should have some money left at the end of the day for more fun stuff! Keep up the good work.  And, thank you for your membership!

 

 

Investment Starters

Q: Where is the best place for a beginner to start looking for investments?? I am in currently in Iraq and don’t make as much money as I would in the civilian world. Where can I put my money to secure my future while I’m here?

-Christopher, Memphis, TN

A: Thanks for your service in Iraq! Let’s do a little “Investments 101!” First, there are three primary investment accounts you can use to build a nest egg for your future: employer-provided retirement plans, Individual Retirement Accounts (IRAs), and non-retirement accounts.

Employer retirement plans typically allow you to invest dollars on a pre-tax basis. In other words, your contributions are not included as income for tax purposes. The money grows tax-deferred and can be withdrawn after age 59 ½. At that time, it will be taxed as ordinary income. There are potential penalties and taxes if you withdraw the money before age 59-1/2. Some employers offer a “matching contribution” if you participate—you don’t want to miss out on that free money. The government’s plan for the military is called the Thrift Savings Plan (TSP), which, by the way, does not currently have a match. Other examples include 401(k), 403(b), and 457 plans.

Next up is the IRA. IRAs come in two varieties: traditional and Roth. A traditional IRA is similar to an employer plan in that the contributions you make may be pre-tax, grow tax-deferred, and can be withdrawn as taxable income after age 59 ½ without incurring a penalty. The Roth IRA does not provide any tax-benefit today, but it grows tax deferred and can be pulled out after age 59 1/2, tax-free, assuming you have held the account for greater than 5 years. You may set these accounts up with the bank, brokerage, or mutual fund family of your choice.

Finally, let’s look at non-retirement accounts. These are simply a bank, brokerage, or mutual fund account that you set-up. There are no special tax benefits to this type account, but there are also no strings attached—you can pull the money out and use it when you need to without IRS penalties (although there could be capital gains tax implications!).

Each of these accounts is an investment vehicle. Within them, you must pick specific investments like stocks, bonds, and certificates of deposit. You should also consider mutual funds, which are accounts in which your money is pooled with a lot of other investors’ money and it is then invested in stocks, bonds, cash investments or a combination. As a beginner, a mutual fund would be a good choice to consider because it would put a professional money manager on your side. If you choose a no-load asset allocation mutual fund, you could have a diversified portfolio with very little in the way of expenses! Asset allocation funds generally invest your money in a variety of U.S. and foreign stocks, bonds and cash. It can be a good way to put your program on auto pilot.

I hope that gives you a feel for the investment “playing field.” But first, I recommend you set aside an emergency fund of three to six months of your expenses. For this you can use a high-yield savings account or while you are deployed, the Savings Deposit Program (SDP). After that, I would consider starting up the Roth IRA. You can easily set this up online from completing the application to making the actual investment! If you can, contribute the full $4,000 that is allowed in 2007 and $5,000 for 2008. Again, a no-load asset allocation fund should be considered. Be sure to find one that is compatible with your risk tolerance. If you plan to stay in the military upon redeployment, the TSP is also a great program I recommend you look into. This should get you off to a good start.

Savings Deposit Program

Q: I am an active duty Navy Corpsman currently serving in Iraq and was wondering if you had any information on the Deferred Savings Program. I was told that it offers 10% to only those serving in combat zones. If you have any information in this issue please let me know.
- Jorge, Newbern, NC

A: Thanks so much for your service. The Savings Deposit Program (SDP) is an excellent way to set aside some money and earn a great guaranteed interest rate while serving in a combat zone. I know from firsthand experience; I did it while I was deployed! Here's how the program works: you deposit up to $10,000 via an allotment, or check, it earns 10 percent interest annually while you are deployed. The deposit will continue to accrue interest for 90 days after your return at which time it's a painless process to have the monies transferred to your bank account. Your local finance office can set it up.

This is a great alternative to a low interest saving, checking account or even a high yield money market account! However, you must keep in mind that the money you deposited in the SDP is generally not available to you until your redeployment. Emergency withdrawal requests must be for the health and welfare of you or your dependents and must be substantiated by a written request from the member's unit commander. For more information from DFAS, visit the following website.

One important caveat: If you have credit card debt, that tax-free combat pay is the perfect opportunity to eliminate it and put yourself on a firm financial footing. First thing's first!

Extra Savings

Q: My wife and I just purchased a house for $129,000 at 6.375%. We currently plan to pay $2,000 per month, and expect to have the house paid off in a bit over 7 years. At the same time, we can possibly save $1,000 per month. We currently have $20,000 in savings that we do not want to touch, for emergencies. What is your best advice to get the most out of our emergency savings (I am guessing a savings account is not the best answer), and the $12,000 a year we can save?
- JD, Moore, OK

A: Wow, you guys are really doing great! And, let me guess...you have a budget and stick to it! All good things come from a well thought-out budget. I hope everyone will read your e-mail and see how great life can be with a reasonable mortgage and no additional debt! It gives you lots of options.

Okay, let's talk about your extra $1,000 per month. First, make sure you are both taking advantage of any matching contributions through retirement plans at work. Next up, if you are eligible, max-out Roth IRA contributions for both of you (a total of $8,000 or $10,000 if you both are age 50 or older). Consider using a balanced mutual fund (a fund with a mix of stocks, bonds, and cash) as the investment within the Roth. A salaried financial advisor will be able to help you pick the right mutual fund. If there is still money left over after these steps, I suggest either contributing more to your employer-provided retirement plans (few things work as well as tax-deferred compounding to grow your wealth!) or setting up a systematic investment into a non-IRA mutual fund account owned jointly by you and your wife. A so-called taxable account gives you the option of using the money for other purposes prior to your retirement years.

Regarding your $20,000 in savings, you're right, the average savings account is likely the wrong place to stash your cash. There are, however, high yield savings accounts available. What you want is your money to work as hard for you as you did to earn it. So ensure you're getting a good interest rate either in a savings or money market account. Currently, a fair rate of interest is about 4.8%. Keep up the good work!

The preceding discussion is not tax, legal or estate planning advice and is specific to JD's situation only. Consult with your tax, legal or estate planning professional regarding your specific situation.

College Tuition Savings Programs

Q: I'm currently enrolled in my state's college fund - the Texas Tomorrow Fund - essentially paying tomorrow's tuition costs today. I want to know the advantages and disadvantages of this program in comparison to 529 college savings plans.
- John, San Antonio, TX

A: I applaud your foresight. Too often folks don't start setting aside funds for college until it's right on top of them! It's amazing how fast 18 years can fly by. The 529 plan comes in two basic flavors: prepaid tuition and savings plans. Your plan, the Texas Tomorrow Fund (now the Texas Guaranteed Tuition Plan) is a "prepaid tuition plan" which, as you said, means you are theoretically buying tuition credits at today's prices for future use. The Texas prepaid fund was closed to further enrollments back in 2003 because the state feared rising education costs and the liability they represented. That should get you to sit up and pay attention as that's one reason why it's not my favorite approach to saving for college. That said, the neat thing about this type of plan is that the state bears the risk of rising education costs, not you. Since you buy "units" or "semesters," as long as the state is solvent, your child will be headed for college in Texas.

On the other hand, with the 529 college savings plan you accumulate funds in a variety of investment vehicles, such as no-load mutual funds, and use those monies to pay for your child's education at the time she is in school - you bear the burden of rising costs. The good news is that your child can use that tuition money in any state for private or public college including some international universities as well. It really provides nice flexibility. Whereas the typical prepaid plan will cover the cost of any public university within the state, however, in most cases if your child goes outside of your state the plan will only provide funds equal to the average cost in your state - this could be quite a penalty! Good luck!

The preceding discussion is not tax or legal advice. Consult your tax or legal professional regarding your specific situation.