Vs.

We’ve decided to go back to paying with cash in order to refocus our efforts in the two particular categories that we have been struggling in: Groceries and Dining Out.  Why don’t we use cash for everything?  There are a couple of reasons:

1. It is inconvenient to make a couple of extra trips to the bank to get cash.  There are a few additional steps (putting money in envelope, remembering to bring the money when shopping, making sure the money comes from the correct envelope)  that I don’t want to include in my weekly routine. 
2. We are not struggling or tempted to spend a lot on the other items on our budget.  It’s not like we get the urge to go crazy at the gas station and buy a lot of gas when we get down in the dumps. Therefore, we will continue to use our debit card for gas and oil changes. 

Our clothes and entertainment budget has, remarkably, stayed well under control the past year.  This is mostly due to our 10 month old.  He has changed our perception of entertainment and has dwindled our shopping time down to nothing.   If these become problematic, they would also transition to cash.

So far, our cash budget has worked extraordinarily well.  I know, it’s only been 3 weeks, but something happened after my last grocery trip.  Historically, we have averaged $98.74 on our big weekly grocery shopping trip and this past week was no different.  This time, however, it hurt me.  When the $100.00 bill came due, I forked over the money (5 $20’s) and walked out.  No big deal. Or so I thought. 

On the way home, I couldn’t stop thinking about paying all of that money for the groceries sitting in the trunk.  Sitting at the stop light, I think I actually verbally said, “Ouch. That hurt.” (Yes, I guess I talk to myself in the car.  That’s a whole different issue for an entirely different blog.)  I resolved to make these groceries last as long as possible, so I don’t have to feel that pain the very next weekend.   These thoughts never crossed my mind when using a debit card. 

Now, when I am at the grocery store, there is an extra filter of, “Do I really need this?” when I shop.  We’ll see the true savings as time goes on, but I intitially think this is going to save 15-20% off our spending.  That’s a yearly savings of $1000-$1500.

This psychological change has proven to me that we are on the right track with using cash for at least groceries and dining out.  I will keep you updated if anything changes. 

What do you use to pay for your monthly expenses?  Does using cash work or is it a waste of time?

We and some of our friends have started to track how much time we spend on looking at grocery ads, clipping coupons, and shopping compared with how much money we save.  I am always skeptical on whether or not it’s really worth the time.  I don’t want to be the guy who drives 30 miles out of the way to save $.05 per gallon in gas, wasting time and a gallon of gas to save $.50 on my ten gallon tank (okay, so I’ve done it a couple of times.)  

With our shopping, we are initially finding that we are earning $15-$30 per hour of ‘work’ on finding deals.  Best of all, this saved money is after taxes.  If you are in a 25% tax bracket, it’s like earning $18-$38 at a job.  We are learning at it is worth your extra time clipping coupons and even shopping at more than one store in order to find the best deals (though I heard that Publix matches competitors offers.) 

There are a couple of good websites for coupons (and I hope that the readers can contribute more websites that I forget. Hint, hint.)   

www.couponmom.com

www.southernsavers.com

Also, attention all nerds!  I need your numbers.  Can you please track your time spent clipping coupons, looking at ads, and shopping as well as your savings.  The more data I collect, the better case I can make that this actually works.

Use Roth IRA as your backup emergency fund

Pros

- Money grows tax free.  This works especially well if you don’t have a major emergency.

- Less temptation to take money out.  It would truly have to be an emergency if you have to withdraw your money and you would be less inclined to take money out for a questionable ‘emergency.’ (You know what these are.)

Cons

- Increased Hassle and paperwork.  It may take a few days to get your money when it’s in a Roth IRA. 

- You can only contribute $5,000 a year.  You can’t use your Roth like a checking account, moving money in and out of your account.  The idea is to put your money in and keep it there. 

Overall

I am not opposed to doing this as long your emergency is not aggressively invested.  I would also keep a portion of your emergency fund in a more accessible savings account where you can get you money in a couple of days.

There’s a problem though.  Up to this point, you were able to take your buffer margin and roll it into the next step.  If you had an extra $500.00 per month going towards your first $1000 saved (simple step 1), you could take that $500 and use it towards your credit card debt (simple step 2), your consumer debt (simple step 3), your emergency fund (simple step 4), your retirement savings (simple step 5), and finally 10% personal savings (simple step 6.)   Now, the 10-15% retirement savings and the 10% personal savings can’t go with you into the next phase.  Something’s gotta give.  I can picture Spencer Pratt from the Hills saying, “That’s the problem.”

"That's the Problem"

What to do? What to do?   As we’ve previously discussed, in order to create more margin/buffer, you must either raise your income or lower your expenses.  If you are like me in this phase, I am sick of lowering expenses by now.  I have had a really crappy car and really crappy phone for way too long.  I’m okay with that, but I just don’t have room to get any crappier.  I’m sorry, Mom, for using that word.  I know, we don’t say that word. (But I’m typing it..hehe)  But it’s true.  I am left with no other choice.  I choose to raise…income.

Here are a couple ways to raise your income.   

Start a side business

Work Part Time

Get a Raise at Your Own Job

Get Promoted at Your Own Job

I will go into each in more detail at a later time, but all four are feasible ways of increasing your income.  Once you get into Phase 3, you will realize that the remaining steps are not very difficult to achieve.  I’ve figured that we will need an additional 7% income to reach Phase 3, Step 3.  Again, we’re not going to go back working 2-3 jobs like we should in Phase 1, but we are confirming our financial success do doing a little extra and going above and beyond. 

If you are ready, (I hope you had a good celebration from the Phase 2 victory) let’s begin Phase 3.

If you are following the Just Ask Money program, you have gone through an intense 12-24 months of debt elimination followed by another 12-18 months building your emergency fund and rolling 10% into retirement savings.  If you are like us, you will need this step just to take care of some expenses that have been put off during the previous periods.   

When we reached this step last year, our cars were 11 and 9 years old with 180k and 135k miles, respectively.  Instead of scrambling to find money when our cars break down (and both of them could go at any time) we proactively started to set aside 10% of our income and put it in the car fund.  We set a goal of $10,000.  Any additional income, gifts, and tax refunds went into this fund.  When this was fully funded two months ago, we moved our 10% to the next goal.   It’s a nice feeling knowing that we could buy two decent used cars if our cars go out.  That’s the beauty of this step.  Preparing for your future.

Are you saving for a house?  There’s a step for that. 

Would you like to start your own business?  There’s a step for that.  (Sorry. That’s annoying.)

Other ideas for Phase 2, Step 3:

Investing

Making updates to the house

Taking a nice vacation

Going back to school

You can tackle 1 to 3 goals at time in this step.  Just allocate different amounts to each task based on priority. 

All of these goals are noble pursuits that will increase your family’s value.  Yes, even a nice vacation counts as a noble pursuit if you experience a new location.  This is the step that will take your family to a new level. 

What does/will your 10% personal savings goals look like?

First of all, there is nothing wrong with leaving your account as is after you leave a company.  You will want to make sure that your account is invested correctly.  That money market that you fled to a couple of years ago when the market was tanking should be getting put to better use if you truly believe your retirement account to be long term investments. 

If you want to move your account and/or consolidate your accounts, you have a few options:

Rollover IRA

You can “roll” your old 401k/403b account(s) into a rollover IRA.  You will, ideally, want to do a direct rollover, which means your 401k company sends your money directly to your Rollover IRA without you physically handling the money.   If your old retirement administrator does send you a check, you have 60 days to get it into your Rollover IRA via a 60 day rollover.  There are limitations to numerous rollovers if you think there are any loopholes,  so don’t think you use a 60 day rollover as a short term loan shark. 

You will do the paperwork at the receiving company.  For example, if Charles Schwab handles your old 401k and you want to move it to Fidelity Investments, you will do Fidelity’s paperwork to open the account and transfer the funds.   Both Charles Schwab and Fidelity are good/cheap places to bring your rollovers.  I would call them and have a rep assist you with the process.  You are bringing new money to them and they will make the process as painless as possible. 

You can move as many old 401k’s to the same rollover account following the same procedure mentioned above.  That means, you could consolidate all of your old 401k’s to one account.  Think of the trees that you would be saving.

Rollover to Your Current Employers 401k

If your company accepts old 401k’s/403b’s, you can move rollover your accounts to your current employers 401k/403b.  Again, you will do the paperwork on the receiver’s end.  Make sure you check if this is possible with your current retirement account administrator.

I actually rolled my previous employers account to my new employers administrator.  I did it to keep things simple and maintain all of my retirement funds in one account. 

A potential downside to moving to a current employers account is that some employers give their employees very few investing options.  This is sometimes a good thing; investing doesn’t need to be complicated.  But, moving your old retirement account to a rollover IRA gives you more investment options and provide free and easy ways to buy into funds.

Taxation of a Rollover

Doing a direct rollover causes no tax implications, but can give you a scare if you don’t keep the proper paperwork or know the tax forms.  Here’s what normally happens:  You move a $20,000 401k from your old employer to a new rollover IRA account.  You’ve done everything right and moved the funds directly.  February comes around and your old 401k administrator sends you a 1099-R tax form stating that you withdrew $20,000 the previous year.  You research what the form means and find out you owe taxes on $20,000 of income that you have not seen. 

To avoid panic when it happens, remember that a 5498 form is on its way from your new retirement administrator stating that you directly rolled this money into your new account and will cancel out the 1099 form sent.  Unfortunately, the 5498 form is one of the last forms to be sent out, so it leaves you anxious for a while. 

What are doing with your old retirement accounts? 

Please note: this post doesn’t cover all situations that can be experienced with a retirement account transfer.  Please check with your tax advisor and your accountant for more details based on your situation.

David Lee Roth converts the splits, but that's not what we're talking about in this post.

Doing a Roth Conversion has become a hot topic this year.  There used to be income restrictions on a Roth conversion, limiting the people who can do this.  However, the income restriction has been lifted this year, leaving the option of being able to take advantage Roth’s tax free growth and withdrawals open to everybody.  Want to learn the difference between the two types of accounts or need a refresher?  Click here.

Converting your Traditional IRA can be beneficial if you have the means to pay your extra tax bill this year.  You can open a Roth IRA at any investment firm and perform this Roth conversion.  I would suggest calling a rep on the phone to perform this for you.  They will be able to answer any questions you will have along the way. 

You can move any portion or all of your account to a Roth IRA.  When calculating how much money to convert, we need to first talk about the tax implications. 

Tax Implications

Remember, you are essentially withdrawing the money out of your traditional IRA account when you convert.  This is going to cause a taxable event.  For example, if you make $60,000 per year and convert $20,000 from a traditional IRA to a Roth, you will need to pay taxes on $80,000 of income.  At a 25% tax rate, you will have an extra $5,000 tax burden. Here are three ways you can fund this extra burden:

1. Suggested: Pay the tax burden with your own additional savings. You have until April 15^th of the next year to save money to pay for taxes on this.  Create a savings fund to pay your taxes.  30 years from now, when this $20k is $300k and you get withdraw it all tax free, you will be happy you made this sacrifice for one year.
2. Not Suggested: Withhold some withdrawn money to pay your tax bill.  Some people will withhold $5k to pay tax and move the remaining $15k into a Roth account.  I don’t like this because it moves your retirement savings in the wrong direction.  If you must, try withholding only half and come up with the remaining amount on your own. 
3. Suggested: If you received a tax refund last year and are expecting another refund next year, use that as a credit toward your tax bill.  If you are expecting a $4000 tax refund this year, find an additional $1000 on your own and you’ve just covered your $5000 tax burden. 

For nerds only: If you want to see what an income increase would do to your tax situation, follow the irs’ tax table:  http://www.irs.gov/pub/irs-pdf/i1040tt.pdf

Once you gauge how much of a tax increase you can handle, you can decide how much to convert to a Roth.  You can move any portion of your account, up to 100%.  Maybe you want to come up with a plan that transfers funds over a 2-4 year period.  Once you understand the tax implications and, more importantly, determine a plan how to pay the one-time tax burden, transferring your account is the easy part. 

For a more comprehensive explanation to any question you may have, go to www.fidelity.com on click on Frequently Asked Questions about Converting an IRA.

http://personal.fidelity.com/global/search/inquira/resultsindex.shtml?question=roth%20conversion

If you Still have questions about converting to a Roth, you can read the below article:

http://personal.fidelity.com/misc/framesets/iwarticle.shtml?pagename=VP1004rothqs

Disclaimer:  This is another broad review of the taxation of a roth conversion.  Please check with your accountant or tax advisor as it pertains to your situation. 

I can already hear the academics writing in with their spreadsheets explaining terms like Future Value and NPV of your money.  I have explored all of these options and on the surface these arguments make sense.  However, the reality is that you cannot be truly wealthy until you get rid of your debt.  How many millionaires hung on to their car payments and student loans while they accumulated their wealth? 

Besides, your postponement of retirement contributions is only temporary and will resume immediately after you eliminate your debt.  Most plans to get out of debt take 12-24 months to complete. 

To make this convenient, your retirement contribution elections are very easy to cancel, alter, and resume.  You should be able to make these elections online with just a couple of clicks on your employer retirement administrator’s website. 

Remember, you have a plan set up to get out of debt as soon as possible.  Cancelling your retirement contributions for a temporary period of time is going to free up additional money to expedite the debt elimination (Phase 1) process and get you into the true wealth building phases.  Once you eliminate your debt and build an emergency fund, you will be getting back into your retirement savings, using the 3 Priorites of retirement. 

I suggest putting 10%-15% of your total income towards retirement.  10% should be the goal if you are 40 years old and under and 15% if you are older than 40. 

This step leaves a few questions that need to be answered on how to invest this 10-15%.  I have listed 3 priorities to maximize your retirement contributions.  If your employer does not offer a retirement plan, skip step one and go directly to step two. 

1. Contribute up to your employers match.  If your employer matches any part of your retirement contributions: do this first and contribute up to the matched amount.  They are giving you free money.  Even if it takes some time to become fully vested (it’s not a type of sweater), use this contribution option first.  My company matches up to 4% of my 401k contributions.  Therefore, an automatic 4% goes into my 401k, no questions asked.  Once that is complete, move to step 2.
2. Roth IRA contributions.  Unless you are 55 or older or you are in an unique situation, a Roth IRA contribution should be your next priority after receiving free money from your employer.  Roth IRA’s can be withdrawn tax free, making this the best long term retirement investment vehicle available.  In 2010, you can contribute to a Roth up to $5,000 a year, per person if you are 50 years old or younger and up to $6,000 if you are 50 or older.  There are some restrictions for Roth contributions if you make too much income (more than $167,000 Modified AGI if married and $105k if filing single) or did not make any income in the contribution year.  Here is the link to the IRS on Roth Eligibility.  http://www.irs.gov/retirement/participant/article/0,,id=188238,00.html
3. After you’ve tapped out your employers match and your maximum Roth IRA contribution, go back to your employer’s retirement plan (401k/403b) and contribute up to your overall 10-15% of your retirement savings.   If you have contributed over $5000 to a Roth, do not contribute to a traditional/rollover IRA.  Your maximum 401k contribution limit is $16,500 in 2010, allowing you to go back and contribute money in addition to your Roth IRA. 

3a. If you do not have an employer retirement plan and have contributed $5k to a Roth IRA, your best plan to invest your additional retirement savings into a taxable non-retirement brokerage account.  This is not tax sheltered, but you can still save for retirement in an account that is not labeled a ‘retirement account.’   These accounts are easy and cheap to set up with a discounted brokerage firm, such as E-Trade, Fidelity Investments, or Charles Schwab.  www.etrade.com  www.fidelity.com www.schwab.com

Let’s Put This into Practice with a Couple of Examples

Jim – 35 Years old, Single Earns $85,000 and has an employer offered retirement plan with a 3% match (at 10%, he will be making $8,500 in retirement contributions.)  Here’s how his contribution breakdown would work:

1. 401k – 3% match = $2,550 (3% of $85,000.00)
2. Roth Contribution – $5,000  (Jim is eligible as he makes less than $105k)
3. Additional 401k Contribution of the remaining $950.00.

Jennifer – 25 year old single, earns $60,000 ($6k contributions), no employer retirement plan.

2.    Jennifer skips step one and contributes $5,000 into a Roth IRA.

3.    The additional $1000.00 goes into a taxable non-retirement brokerage account since she has no employer retirement plan. 

Setting these three Priorities up is not as difficult as it looks.  Simply set up a direct deposit for each step and forget it. 

Disclaimer: Please note this is a very broad outline of retirement contributions and leaves out a lot of details that may be pertinent to your situation.  Please speak with your accountant/tax advisor with if your situation falls outside the guidelines mentioned in this post.

This post will start a series around Phase 2, Step 2 – 10-15% Retirement Savings.  Before we invest 10-15% of our income into retirement, we need to learn how they work. 

Tax season has come and gone again this year (hopefully this isn’t news to you) but I wanted to outline some very basic guidelines on retirement accounts and its taxation.  It’s important to understand how these accounts work in order to make sound retirement investment decisions. 

Before we breakdown the taxation of various retirement accounts, let’s get one thing straight: you WILL pay taxes.  The only two things that are certain in life are death and taxes.  Now that we know this, we can explore WHEN we will get taxed based on the type of retirement account you have set up. 

Taxed Going Out (Upon Withdrawing Money) – 401k/403b/Traditional IRA/Rollover IRA/SEP/Simple

No matter what the name of your retirement account is (401k/403b/Traditional IRA/Rollover IRA,) the way you pay taxes is the same.  Your tax benefit takes place when you contribute your money as a ‘tax-deductible’ contribution.  That means you get to deduct your contribution amount on your income taxes. 

Let’s say you are 30 years old and earning $100,000 per year (good for you, by the way) and are paying taxes in the 25% tax bracket.  Based on these general figures, you would owe $25,000 in taxes.  If you make a tax deductible contribution of, say, $5000, you would now be paying taxes on $95,000 worth of income, making your tax bill $23,750 (25% of $95,000), $1,250 lower.  The $1,250 is your tax your benefit. 

Now, remember I said the government is going to get theirs and you WILL get taxed on your money at some point?  In these types of retirement accounts, you will pay taxes when you take your money out.  You have deferred paying your taxes, thus the term ‘tax-deferred’ account. 

32 years later and an average of 9% return on investment, the $5,000 contribution has now grown to $80,000 (you don’t believe me, calculate this yourself.  Compounding interest is a beautiful thing.)  You decide to withdraw half of the funds, or $40,000, in 2042, when you are 62.  Your income in the year 2042 is still $100,000 (slacker) and President Obama IV still has taxes at 25%.  This year, however, when you do your taxes, you will be paying tax on $140,000 worth of income.  If this additional income doesn’t put you in a higher tax bracket (and it probably will) you are going to pay at least an additional $10,000 in taxes.  I told you the government will get theirs!  In these accounts, you get taxed on the way out, when you withdraw your money. 

If you decide to withdraw your money before the age of 59 1/2 without a valid exception, you will be paying an additional 10% on the money you take out (yes, an additional $4,000 out of the $40,000 withdrawn in the above example.)  

Do you think you can hide your money in this retirement account forever? Think again.  Mandatory retirement distributions, also referred to as MRD’s, require you to take a portion of your retirement out when you turn 70 1/2.  Why?  So you can pay taxes, silly.   

Taxed Going In (Upon Contribution)– Roth IRA, Roth 401k

With a Roth account, both the IRA and 401k, you pay your taxes upfront and receive the benefit when you withdraw funds.  This type of account faces the inevitable and pays the taxes up front.  It’s the bizarro Traditional IRA, where you receive the benefit up front and pay taxes on the back end.  

Therefore, if we use the same example above, but contribute to a Roth IRA/401k, you will still pay taxes on your full $100,000 income this year after you make a $5,000 Roth contribution.  There is no tax benefit for this year.  By using a Roth IRA, you’ve missed out on this year’s potential tax savings of $1,250 compared to a traditional IRA/401k. Don’t worry though, this story has a good ending.

32 years later, when you withdraw $40,000 out of your $80,000, you can take this money out tax free!  That means you receive $40,000 in your pocket and the government can’t touch a penny of it. 

With a Roth IRA, you can withdraw money up to your contribution amount ($5000 in the example) without penalty before the age of 59 1/2.  You can also hang on to the money in this account as long as you want.  The government already got their taxes, so you can keep in it in this account and let it grow without being forced to take money out at 70 ½.  Imagine holding on to this $5000 contribution for 16 more years until you are 78 and you have a $320,000 account that you can withdraw tax free.  I can hear Cosmo Kramer saying, “Now that’s some sweet action!”

A disclaimer from Bryan: Please note that this is a broad overview of the taxation of retirement accounts.  Additional rules may apply.  Please consult with your accountant and tax advisor with questions relating directly to your situation.