Handling the Bank Bailouts

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As of this writing, the Citibank closed the previous day’s trading at $1.20 per share.  This gives them a market capitalization of just over $6 billion dollars.  Specifically, this means all the common stock of Citibank is worth $6 billion dollars.  In November, the US Government “injected” $20 billion and guaranteed $306 billion of Citibank’s assets.   Citibank has been “bailed out” repeatedly and has had a total of $45 billion of taxpayer money channeled to it.1 This leads to one simple question:

How is Citibank Solvent?

Of course the answer is, it isn’t.  But that leads to the question:  how is its common stock still worth $6 billion? 

Currently the governmnet is propping up a company to retain value for investors who should have been wiped out already.  Sure they have been diluted by government injections, but that seems a poor punishment for investing in an utterly insolvent company.

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1. NWAnews.com – Citigroup Deal 36% portion for U.S. [↩]

Investing Step 10: Techniques

This post is step 10 in our Investing Template.

Once you’ve decided how your money should be allocated, it then becomes a matter of execution.  There are many details that can make a tremendous difference in how your returns are realized.  How you get your money into its allocation is nearly as important as what allocation you choose.

Diversification

Diversification is a term you hear a lot.  It basically means making sure all your eggs are not in one basket.  While economic crises can affect all asset classes, in general when one does poorly, another does well.  Thus if you have your money in a variety of areas, you will generally get better returns.  Additionally, this applies to stock and is a compelling reason to buy mutual funds. 

Index Funds

Once you’ve settled on buying mutual funds, index funds are often a very reasonable approach.  Their goal is to roughly match the returns of various well known stock market indexes like the S&P 500 or the Dow Jones Industrial Average.  By buying into an index fund, you have gotten a tremendous amount of diversity in your stocks.  Additionally because they are essentially unmanaged, you are paying low maintenance fees and not subject to your money manager’s strategy becoming outdated.

Dollar Cost Averaging

Fortunately, for many of us this happens naturally due to the way 401(k) contributions are handled, but for the rest of us this can be very important.  Timing the market is a dicey proposition for experts, so for those of us simply trying to get reasonable returns it is a terrible idea to put all our money into a particular investment vehicle at once.  Instead the goal is to buy a fixed dollar amount of each vehicle every so often, maybe every month.  As a result, you will buy more when the price is lower and less when the price is higher.  This should help prevent catastrophic entry points and your average price should be favorable.

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Investing Step 9: Allocation

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This post is step 9 in our Investing Template.

After all your tax-deferred accounts are being used to their maximum potential, it is time to fund any other accounts.  Once that is done, you need to start deciding how to allocate your funds.  This is the problem that many people did not properly address before the real-estate bubble burst and is the most important step to maximizing your returns.

Time Horizon

As we’ve discussed, the first thing you must decide in each account is how soon you will need access to the money.  You need to create an allocation based on this and adjust it accordingly.  Typically the more risky investments will even out over time and give the best returns, but can give horrible returns in the short run.  Thus the sooner you expect to use the funds, the less risky your choices should be.

For example, many people who were expecting to retire soon are suddenly in a state of confusion, because they left their investments in stocks and had massive negative returns.  This can be crippling for someone who was expecting to retire next year.  If they are expecting to retire in 20 years, there’s a good chance their investments will rebound.  However, if your time window is getting close you should be moving to safer, less risky investments, including cash.

Risk Aversion

In addition to the wisdom of avoiding risk when you are getting close to withdrawing funds, some people are very reluctant to put their money at risk at all.  If you are in this class, you should probably look to maximize your returns with very low or no-risk investments.  There are still many options available, even when capital preservation is a high concern.

The Spectrum

Here is a rough guide of some types of investments to consider, from least risky, to most risky:

•         Short Term Loans to Stable Government Entities
•         Mid and Long Term Loans to Stable Government Entities
•         Short Term Loans To Stable (Blue Chip) Companies
•         Long Term Loans to Stable (Blue Chip) Companies
•         Real Estate
•         High-Yield Debt (junk bonds)
•         Equity (Stocks and Mutual Funds)
•         Futures and Options

Real estate property has long been considered a safe investment, but recently this has been put into question.  Like any investment vehicle it is more easily navigated by experts and it is also very difficult to diversify.

Futures and options are best left to the pros.  In fact I recommend against even investing in individual stocks.  We’ll talk more about this in the next section.

Investing Step #8: Health Savings Accounts

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This post is step 8 in our Investing Template.

The Health Savings Account is becoming a more popular option recently.  It is a great opportunity to save money on your medical insurance.  Despite that, it is still an under-used option. 

Health Savings Accounts allow you to contribute money to an account whose funds are designated specifically for health uses.  While many people might not immediately see the value in this, it represents an option in which you can almost immediately recoup a large percentage in savings.  If you are in a 33% tax bracket, then every expense you make using this account is essentially at a 50% discount. 
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Investing Step #7: Home Ownership

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This post is step 7 in our Investing Template.

While there are no explicitly tax-deferred savings plans for housing, the Roth IRA can work very much like one.  If you are looking to buy your first home in the future, more than 5 years from now, or if you have a Roth IRA opened already, such an account may be a very reasonable option for your investing dollar.  While you cannot take your contribution out pre-tax, any income you make over those 5 years can be used tax-free to buy a house, up to $10,000 per person.  This can be a considerable savings.

While retirement and college may seem like distant issues, buying a home is much closer on our investment timeline for most of us.  If you already own a home, or have in the past, you can pretty much skip this section as a Roth IRA will not do you much good.  Its exemption for buying a home only applies to first time buyers, but it can be very powerful for those looking to maximize their earnings.

Your Strategy

When you contribute to your Roth IRA, the account must have been opened for 5 years for you to be able to withdraw money to help buy your first house.  Additionally, you can only withdraw a maximum of $10,000 per person.  This means that if you are married you can withdraw $20,000.  If you are slowly saving for a house, putting money into an Roth IRA can be a great option, since all of your investment proceeds can be used without ever paying any tax on them.

Generally your approach here would be to contribute money towards your Roth IRA until it looks like your window is getting close.  At the point where you approach your maximum contribution for your home, you will have to consider whether continuing to contribute to your Roth makes sense.  You may have better options for your other investment goals, but why pay taxes on your home down payment investment when you don’t have to?

An Example

Imagine if you want to buy a house in 10 years.  Each year you put $1000 in your Roth IRA and it earns 11% (a lofty goal, but it helps illustrate the power.)  If you pay 33% in taxes each year, by the time you were ready to buy the house you would have almost $3,500 more dollars in your Roth IRA than you would in a regular investment account.  The Roth would have $18,561 vs $15,097 in the regular account.  You made $3,500 simply by selecting the right account in which to save your money.

This is a fairly narrow option.  It only applies to those who have never owned a home and who can qualify for the specifics of the Roth IRA, bu it should be included in your timeline if it applies to you.  Dedicate some of your investment funds to your Roth and you can get the massive returns that the absence of taxes can provide you.

Investing Step #6: College Saving

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This post is step 6 in our Investing Template.

After retirement, the next farthest investing event is your kids’ college education.  While in some cases a first house may be sooner than college, or in more rare cases retirement might come before your kids go to college, generally money that is invested in College Savings Plans will be tied up the second longest, next to your Retirement Accounts.

Why College Savings Plans?

College Savings Plans, often referred to as 529 plans, allow you to contribute money towards future tuition, have that money grow tax-free, and if it is used for appropriate expenses, used without paying taxes.  Thus, while your contributions are not typically pre-tax, they grow without taxes and can be used without taxes, which can be a huge advantage.

Types of 529 Plans

There are two major variations in 529 plans:

• Prepaid Tuition: In this case you pay for tuition at today’s rates and they are locked in for the future.
• Savings Plans: These allow you to contribute your after tax dollars to grow tax free and offer various investment options.

Overall, 529 plans are implemented at state levels, or sometimes even at the particular institution level.  Thus you see a much wider variety in options and details than in many federal plans. 

Considerations

Due to the wide variety in the plans there can be many key details, but ultimately the primary consideration in these plans is the likelihood that this money will be used for college.   If it is not, then the money will be taxed when withdrawn, as well as a 10% penalty, similar to early withdrawal in a retirement account.  At the same time, college can be a major expense in a family’s life, and the tax benefits of these accounts can be huge.

When deciding if and how to contribute to a college savings plan, I typically recommend caution.  While these plans can offer huge savings if your child goes to an appropriate college, that is not a guarantee.  Many other expenses will definitely happen and are slightly safer options because you can guarantee their use. 

Still, this money should not be viewed as a terrible investment either way.  If you use a typical college savings plan for 15 years and then your child doesn’t go to college, you can withdraw that money with a 10% penalty.  While this may sound harsh, you’ve had 15 years of your gains compounding without taxes, which will generally overcome the 10% penalty.

Investing Step #5: Retirement Accounts

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This post is step 5 in our Investing Template.

Retirement accounts are probably the type of tax-deferred vehicle with which people are the most familiar.  The number of people invested in the stock market has skyrocketed in the past two decades, much of which is owed to tax-deferred retirement accounts.  Some examples of these types of plans are:

401(k) – The most common type of plan.  They are generally offered through for-profit companies and often include matching.

403(b) – 403(b) plans are similar to 401(k) plans, but are offered by public schools and some non-profit organizations.  There are other differences, but that is the most obvious one.

Traditional IRA – IRAs are also tax-deferred accounts, but are not implemented through an employer.  You are able to deduct the amount contributed and it grows tax-free.  You pay taxes on the funds when you withdraw them. 

Roth IRA – A Roth IRA is different from a traditional IRA in that you do not get to deduct your contributions from your income from this year.  However, like an IRA the money grows tax free and you can withdraw it without paying taxes when you withdraw.  Additionally, there are a few exemptions available to withdraw from a Roth IRA before retirement that are not available with other vehicles.

Self Employed IRAs – There are several other types of IRAs, such as a SEP-IRA and SIMPLE IRA,  available to people who are self-employed, which can allow them significant deductions as well.

All of these programs have different income limits and contribution limits, and a wide variety of details.  Make sure to do considerable research and consult with a tax professional before deciding which one is appropriate for you.

Your Strategy

Which of these accounts make the most sense for you can be complicated, but keep these things in mind:

If your company matches your contribution, it is almost always wise to maximize your contribution to the point at which they match.  Even if they only match 33% or 50%, you are still making an amazing return immediately. Many companies match up 100%!  Imagine a guaranteed return of 100% instantly.  It’s an incomparable investment.  This should usually be your number one investment destination after you’ve established your emergency fund. 

With the exception of the Roth IRA, these are funds you should be setting aside for retirement.  That means that this is the longest window in your time horizon.  These are essentially your funds for when you don’t want to work anymore.  Thus, you should only tie money up in these funds that you will not need for a long time.  There can be severe penalties for withdrawing this money before you reach retirement.

By the same token, if you are setting money aside for retirement, there is no reason not to get it into some kind of tax-deferred vehicle.  Once you are comfortable that you can afford to deisgnate this money for retirement, at a bare minimum you want it to be able to grow tax-free.

Investing Step #4: Tax-Advantaged Accounts

This post is step 4 in our Investing Template.

Why pay taxes?  A lot of people claim they wouldn’t if they didn’t have to. However many of us are voluntarily paying taxes on money we could be pocketing tax-free with tax-advantaged accounts.  These are investment accounts where your taxes are either paid when you take the money out, or sometimes not at all.  Many people are familiar with retirement accounts like 401(k)s or IRAs, but there are other options that are often overlooked entirely.  Many times, if you know you’re going to have an expense in the near future, you can pay for that expense tax-free.  This many not seem like a big deal to you, but let’s do some simple math.

If I have a $100 expense this year and I’m in the 33% tax bracket, I have to earn $150 to pay for this expense if I have to pay taxes on the income.  If, on the other hand, I don’t have to pay taxes, I only have to spend $100.  This means that if I “invest” that money in tax-advantaged accounts that allow me the option to put away a certain amount pre-tax, I’ve immediately made 50% on that money.  A 50% guaranteed return is unheard of anywhere else, yet many of us overlook opportunities to achieve these same returns daily.  We’ll look at 4 broad categories of accounts that allow you to either defer, or completely avoid taxation on your income.

Tax-Deferred Accounts

• Retirement Accounts
• College Tuition Accounts
• Home Investment Accounts
• Health Savings Accounts

While each of these programs have nuances, they are closely related to your investing timeline.  Health Spending Accounts are for near-immediate expenses, home accounts are usually a fairly short timeline, college programs can be quite a while in the future, and retirment accounts are often the furthest off.   This collection of accounts can save you a great deal of money if used properly, so we’ll look at them individually over the coming days.