Financial Tips for New Grads

Investing Tip of the Month

What would you tell a new college graduate if you could? Would you espouse the virtues of starting a career in the plastics industry, wearing sunscreen, or having the courage to follow your heart?

We recently asked Morningstar users to weigh in with their best financial advice for new college graduates, and they were eager to share their wisdom. A few key themes quickly emerged: Live frugally, start saving–even if it means starting small, and do what you love. And when it comes to your investments, stick with the basics.

Driving an Old Honda Now Means Peace of Mind Later On
One of the key pieces of advice readers imparted falls into the category of what not to do: Don’t let those first paychecks slip through your hot little hands. Users shared firsthand experience, noting that driving older cars and bunking with Mom and Dad had paid great dividends in the form of peace of mind later on.

VALUEINVESTOR wrote, “One of my finance professors told our class ‘Buy a used Honda, and save as much as you can in your retirement account in an index fund.’ I have never forgotten this advice. I think one of the most common things graduates do when beginning their careers is acquire all the trappings of success before they are successful. I see most of them buying new cars, nice clothes, fancy apartments, or the biggest house they can afford. At the same time, they put little emphasis on building an emergency fund and saving for retirement. I would repeat the advice I received: Don’t waste money on material things, and save as much as possible, as early as possible. Most grads are accustomed to living on a small budget, so keep it that way for a while. It could save years of misery ahead.”

The virtues of debt avoidance was a recurrent theme, with posters noting that taking on debt isn’t only financially crippling, but can also limit one’s life choices.

MarginofSafety stated plainly, “‘Stuff’ will accumulate over time. Do not accumulate debt to pay for ‘stuff.’”

Allenjam also advised discipline on the debt front. “Pay cash or at least pay off your single credit card every month. That kind of discipline will pay off handsomely by preventing unneeded purchases and avoiding usurious credit charges by the card companies.”

Finally, Bill1234, ever the romantic, wrote, “Bag that big, lavish wedding when the day comes. You are not a prince or princess. The day is not made special by how much you spend. Take the money that would have been spent on your special day to pay off debt. Go into marriage with a clean slate.”
Have a Backup Plan
Several users noted that the key way to stay out of debt is to make sure you have ready cash on hand to pay for unanticipated expenses.

Scott123 laid the groundwork. He wrote, “Set up an emergency fund of at least three months of living expenses in a high-interest online bank account. If you’re self-employed or work on commission, you will want to have more cash liquid regardless.”

MarginofSafety noted that having an emergency fund can have spillover benefits for other parts of a person’s financial life. “Learn that by having an emergency fund, you can save a large amount on insurance costs of all types (vehicle, home, and health insurance) by having a larger deductible. A basic principle of insurance is to exchange a certain small and known cost for an uncertain and unknown large cost. I see a large number of otherwise intelligent people of all ages paying huge insurance costs to have first-dollar coverage–this is a waste. An emergency fund also helps you not have ‘emergencies’ that require debt to fund them, especially credit card debt.”
Just Do It
For other users, their key advice to new grads was to get started with saving and investing, even if it means starting small.

FidlStix spoke from experience about the virtues of not tarrying when it comes to saving and investing. “Coming out of a famous West Coast college in the mid-60s, idealistic, and very much into the hippie scene, I was totally impervious to financial advice or anything to do with saving money. Now, these older, wiser eyes see my world quite differently. I’d tell a new grad to save, save, save, and learn the basics of investing your money, so you have a shot at being financially independent when you’re no longer working. I waited almost too long to take hold of the notion of saving and investing.”

Winstondunn urged new grads/new investors not to be deterred if they make a few mistakes along the way. “As soon as you have a job and stable income, invest in stocks every month. Put aside the money that you need for living that month, put aside an emergency fund (for example, three months of living [expenses]), then invest in stock. You will be clueless in the beginning and make a few mistakes, but you will lose little money because you don’t have much money at the beginning. You will gain experience from your mistakes. In a few years, you will have more money to invest, with more experience.”

Cutthroat pointed out that you don’t even need to have cash to start the learning process. “Even if you don’t have the cash to do it, create a phantom portfolio and watch it. Learn how the markets move and how to balance the portfolio regularly.”
Life Matters
Recognizing that personal finances are deeply intertwined with a person’s priorities and values, some posters offered advice on life matters as well as financial ones.

In addition to providing some financial pointers, Larry3 advised, “Work hard and have fun” and “do something good for someone every day.” Can’t argue with that.

Scott123 wrote that squirreling away money isn’t the only worthwhile way to deploy cash. “Make investing/saving a priority, but don’t forget to set aside some funds for your quality of life, like going to sporting or entertainment events, taking vacations, particularly to see family (why haven’t you called?), or giving to charity.”

Finally, RetiredinFL spoke for all of us with this evergreen life advice, “Be yourself, not what somebody else wants. Set short- and long-range goals. You will achieve what you really want. Help others who are in need.”

A version of this article appeared on Morningstar.com on May 22, 2011.

Will Your Retirement Savings Meet Your Needs?

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Investing Tip of the Month

Current and future retirees have some important advantages over folks who retired even a few decades ago. Thanks to advances in medicine and healthier lifestyles, a person retiring at 65 today can and should plan for 20 or more relatively healthy years.

But with improved longevity comes challenges. Given very long time horizons and the fact that the majority of today’s retirees don’t have pensions, the risk of a retiree outliving his or her nest egg is a very real one.

So how can you tell if your retirement portfolio is on the right track to sustain you for the rest of your life? Here are the key steps to take.

1. Estimate income needs.
The first step when gauging your retirement portfolio’s sustainability is to estimate your in-retirement income needs. (This will obviously be easier for those who are closer to retirement than it is for younger savers for whom retirement is 20 or 30 years in the future.)

As you do so, be realistic about what you’ll actually spend. Conventional wisdom had been that retirees will need about 80% of their preretirement expenditures, owing to savings in categories like commuting, lunches out, and not having to save for retirement anymore. In reality, some retirees actually spend more than they did when they were working, owing to big-ticket costs like travel and medical bills. Others, meanwhile, spend a lot less.

2. Estimate longevity.
How long does your portfolio need to last? Who knows? But it’s better to plan for a good long life rather than risk falling short and becoming a burden on your loved ones. You can use the Social Security Administration’s life-expectancy calculator (http://www.ssa.gov/OACT/population/longevity.html) to find the average life expectancy for someone of your age.

3. Gauge certain sources of retirement income.
The next step when determining your retirement portfolio’s viability is to round up any income you expect from sources other than your own retirement savings, including Social Security, part-time work, pensions, and annuities.

For a specific read on what you can expect from Social Security, use the Retirement Estimator calculator on the Social Security Administration’s website. Alternatively, you can submit a request for a personalized Social Security statement. Also, bear in mind that the amount of your Social Security income will depend on when you begin collecting.

If your Social Security benefits seem too skimpy, they might be. Not reporting name changes, using a name other than the one on your Social Security card, or entering an incorrect Social Security number can lead to inaccurate benefit calculations. Troubleshoot by checking your benefits every few years.

Projecting what your retirement or pension plan will provide requires more legwork. First, know the factors behind your expected future payments. Defined-benefit plans, such as a pension, often are linked to Social Security payments; consequently, a fatter Social Security benefit could mean a slimmer pension check. Second, be persistent about seeking information. Some plans will update you regularly about your benefits as you near retirement. Others aren’t as accommodating. Pester your employer’s human resources department for more information. If you get the runaround, turn to Washington. Call the Pension and Welfare Benefits Administration (800-998-7542) to find the Department of Labor office in your area.

4. Find the size and asset allocation of your retirement portfolio.
Now it’s time to get a current read on your investment portfolio. Gather up your most recent statements for all of the assets you have earmarked for retirement–IRAs, company retirement plans, and taxable accounts.

Enter each of those holdings into Morningstar Investment Research Center’s Portfolio X-Ray tool. Take note of your aggregate retirement savings amount (the total dollar value of portfolio), then click View X-Ray. Jot down how much you have in stocks, bonds, and cash.

5. Determine whether your current portfolio will support your desired level of income.
Armed with these key pieces of information–your expected income needs and longevity, your portfolio size and asset allocation, and your expected income from other sources–you’ll be able to make a reasonable judgment about your portfolio’s sustainability.

6. Make necessary adjustments.
Does your retirement portfolio appear to be on track? If so, give yourself a pat on the back and stick with your savings program; you’re obviously doing something right. But if it looks likely that you’ll fall short, you’ll have to tweak whatever variables you can–save more, work longer, invest more aggressively, or all of the above.

A version of this article appeared on Morningstar.com on Feb. 16, 2011.

The Library provides Morningstar Research Center for local patrons with a library card and PIN.

Learn how to use Morningstar Research Center tomorrow April 7 at 11 am Central Time.

Patrons can register by e-mailing librarytraining@morningstar.com and mention Las Vegas-Clark County Library District.

Backdoor Roth IRAs Could Cost Some Investors at Tax Time

Investing Tip of the Month

by Christine Benz, Director of Personal Finance at Morninstar

You may have seen several mentions of the so-called backdoor IRA during the past year and a half. Despite its illicit-sounding name, this maneuver is perfectly legal, and it can help you diversify your retirement portfolio’s tax treatment.

However, if you have other IRA assets that haven’t been taxed yet, you need to think twice before engineering a backdoor Roth. If you don’t, your new Roth IRA could cost you a lot more in taxes than you had planned.

The Maneuver
Before getting into how a backdoor Roth can be costly from a tax standpoint, let’s first discuss how this move, when properly executed, works and how it can be beneficial for savers in certain instances.

First, it’s worth noting that a backdoor Roth is only appropriate for those who earn too much to contribute to a Roth the conventional way: For 2010, the maximum adjusted gross income cutoff for married couples filing jointly is $177,000 and the income limit caps out at $120,000 for single filers. If your household’s income is below those thresholds, you can get into a Roth through the front door.

But assuming that your income is higher than that, you can take advantage of the fact that beginning in 2010, there are no longer any income limits on who can convert a traditional IRA to a Roth. Don’t ask me why Congress has left open this gaping loophole, because it doesn’t lead directly to new tax revenue, but for now it provides a way for higher-end investors to get new assets into a Roth.

Say, for example, a 55-year-old with an adjusted gross income of $185,000 and no other traditional IRA assets puts $6,000 into a traditional nondeductible IRA. (The “nondeductible” piece means that his contribution consists of money that has already been taxed; he can’t deduct his contribution on his tax return because he earns too much.) He could then immediately convert that IRA to a Roth, thereby ensuring tax-free withdrawals on that money in retirement.

Normally, the big hitch with an IRA conversion is that converters owe taxes on the part of their IRAs that haven’t been taxed yet, such as any deductible contributions or investment earnings, including money rolled over from a traditional 401(k). But assuming the backdoor converter doesn’t see the value of his IRA shoot up between the time he opens his account and the time he converts, his tax bill on the conversion would be minimal or even zero. That’s because he already paid taxes on his contribution, and he’ll have limited to no investment gains on which he’ll owe taxes at that point. In addition to avoiding taxes on the conversion, he’ll also have gotten some of his retirement assets into the tax-free withdrawal column, which is beneficial for people like him who have, up until now, earned too much to contribute to a Roth IRA.

The Maneuver Gone Awry
Remember, however, that the above example hinged on the fact that the backdoor IRA converter had no other traditional IRA assets. Let’s take a look at another example–one with other IRA assets in the mix–to illustrate how setting up a backdoor IRA can spell extra taxes.

Let’s assume a 32-year-old woman who earns $200,000 a year and has $20,000 in traditional IRA assets puts $5,000 into a traditional nondeductible IRA, seeking to take advantage of the backdoor conversion option. At first blush, it seems like this converter shouldn’t owe any taxes, either. Her contribution to the new IRA, as in the previous example, was already taxed, and if she makes the conversion right away, before her investment goes up in value, she wouldn’t owe any taxes on investment gains, either.

But here’s where the tax pain comes in. Her other traditional IRA assets consist entirely of money that she had rolled over from an old 401(k) plan, meaning that money has never been taxed. (With traditional 401(k)s, you’re not taxed upon your initial contribution and you’re not taxed on your investment gains until you begin taking money out.)

Because of those other IRA assets, the tax she’ll owe upon conversion will depend on percentage of taxable versus tax-free assets in all of her IRA accounts, not just the one she just opened.

In her case, $20,000 of her IRA assets haven’t yet been taxed and her new nondeductible IRA contribution of $5,000 already has. That means that 80%, or $4,000, of her recent $5,000 contribution would be taxable upon conversion; only $1,000 (the other 20%) would not be.

All of this means that if you have other traditional IRA assets, or SEP and SIMPLE IRAs, you’ll need to proceed carefully before opening up a traditional nondeductible IRA with an eye toward immediately converting to a Roth. This maneuver can work beautifully for those with no other IRA assets, but it can be a tax headache with those who do. Check with a tax advisor before proceeding. You may also be able to conduct a series of partial conversions over time, thereby limiting the tax hit in any one year.

It’s also worth noting that you have an escape hatch if you would like to do a backdoor IRA but have other IRA assets that you’ve rolled over from a previous employer’s 401(k). Assuming your new employer also has a 401(k) plan that allows you to do so, you could roll the IRA assets into that plan, thereby reducing or eliminating the taxes owed upon conversion of a new backdoor Roth. Of course, the merits of this strategy will depend entirely on the quality and fees associated with the new plan.

A version of this article appeared on Morningstar.com on Jan. 3, 2011.

The Retirement Cost Calculator

Getting ready to retire or want to see what it takes to reach your retirement goal?  Check out this great tool found in Morningstar Investment Research Center.

The Training Corner | by Lars Wasvick, Associate Product Manager

The Portfolio page is one of the new features on Morningstar Investment Research Center. Not only does it provide you with investing and asset-allocation commentary, but it also includes some great new tools. One of those is the Retirement Cost Calculator.

With our retirement tool you can quickly define retirement target goals. The calculator allows you to calculate such things as how much savings you need to retire, how much you need to save, and what level of return you need to reach the goal.

To access the tool, click on the Retirement Cost Calculator link under the Portfolio section on the homepage, or go to the Portfolio page and select it from under Calculators. Once the page is loaded, you will have the option to solve for annual retirement income, current and annual savings needed, and annual return needed.

You can get your results by inputting your information in the spaces provided for circumstances. Such things as your age, gender, returns, and savings will be taken into account to determine the results.

For example, if you would like to get $30,000 in annual income when you retire, the calculator will help you determine what you need to save each year to reach that goal. To do this you will need to input your income requirement, current savings, and annual return.

One question you may have is what the annual risk-free rate is. This is the interest an investor might expect a risk-free investment to generate over a period of time. An often used number for this is the three-month Treasury Bill yield, which you can find on the Markets page of the database.