FPU Week 10: From Fuition to Tuition

We're hitting the home stretch! Just three lessons to go after this. Arguably, these last 4 lessons are the heaviest. Not only due to the material, but also from the build-up of information of the previous 9 lessons.

Week 10 is the one that has a tendency to knock the wind out of folks. It's understandable - you're still in debt, just getting Baby Step 2 going, your budget is still frustrating you, and now you want to talk about investing!?! It's a daunting subject as-is.

Here was my advice to the folks freaking out after this lesson:

Absorb what you can now. Later when you approach Baby Step 4, you can listen to the lesson again, and spend more time on it.

It's a double-edged sword - It's tough to master all of this in 13 weeks, but it's great that Dave gets people thinking about this stuff even before it's time.

So let's go over the basics:

Baby Step 4 is: Invest 15% of you income in tax-favored plans

Tax-favored plans are ones that are qualified by the government, meaning there is a section in the tax code that outlines how these work. These are not accounts, but as Dave describes, these plans are the coats that keep the accounts 'warm'. These are arrangements that keep the IRS's greedy hands out of your money. For retirement, these include:

  • Individual Retirement Arrangement (IRA) - Anyone with an earned income can use an IRA to save for retirement. There is a cap on the amount you can contribute, and there are thousands of funds to choose from on the open market. A traditional IRA is a pre-tax investment, meaning that the money is pulled from you paycheck before taxes are taken out. To that end, taxes will be charged at retirement when you take distribution of funds. A Roth IRA works a little different in that it uses after-tax dollars. Since you are taxed on the money now, your money grows in that account tax-free!
  • Simplified Employee Pension Plan (SEPP) - This is one that you don't hear about very often. It is designed for people who are self-employed and allows them to invest a portion of their net profits. It too is capped, but the cap is much higher with a SEPP (2007 caps were $8k for IRAs vs $45k for SEPPs)
  • 401(k), 403(b), 457 - These are employer-sponsored plans, meaning they are offered where you work. They usually include some type of match and/or contribution by the employer. Most employers will match your pre-tax contributions dollar-for-dollar up to 3%, though that amount can vary. The names of these plans simply denote the portion of the tax code that enables them - Section 403, sub-section (b).
You are not limited to any one, or one type of retirement accounts. I, for example, have a Roth IRA, a SEPP, and a 401(k). The SEPP was from a job where it was just the owner and myself. He was using a SEPP for himself and the easiest way he could offer retirement savings was to contribute to my SEPP. During that time, we also set up a Roth IRA as we were able to save more at that time. The 401(k) is from my current job.

Dave recommends....
taking part in your employer's plan up to the match, then contribute to a Roth IRA up to the cap. If you still have not hit the 15% mark, then go back and contribute more to your employer's plan.

One final note: when you leave a job, you need to roll the money from your retirement account to a new one. The rollover needs to be between like-accounts - pre-tax to pre-tax, after-tax to after-tax. You financial adviser can help you with this to make sure it happens right.

Baby Step 5 is: Save for your children's college using tax-favored plans
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Again, there are plans set forth by the government that allow tax-advantaged investment, this time for college savings.
  • Education Savings Account (ESA) - These are also know as 'Education IRAs' as they act like a traditional IRA, but the money is for college expenses only.
  • 529 plans - These are sponsored by individual states and are usually open to anyone, no matter where you live. For example, living in Texas, you can take part in the Pennsylvania 529 (assuming it suits you). What is difficult about these, is that they are all different. Some are excellent plans that allow you to control what you are invested in. Others automatically switch investments based on the child's age.
Also be careful as some of these 529 plans are in dire straits right now. Some of these plans have been so poorly managed or were poor investments to begin with that they are insolvent. Alabama's 529 program is $460 million short, and is currently closed to new investors.

Dave recommends.... to first use an ESA. They are the simplest and have fewer pifalls than 529s. Beyond that, you can look at 529s, but beware of those that are inflexable on the investmetns or use a 'pre-paid' tuition plan.

Does all of this make your head spin? Are you invested to the hilt? Where are you in investing?


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