Suze Orman's Action Plan (12 page)

ACTION:
Choose the financial institution you want to move your money to (that’s the rollover part) and that company will help you switch the money from the 401(k) into your new IRA account. I believe keeping your costs as low as possible is vitally important, so I recommend discount brokerages or no-load fund companies that also have a low-cost brokerage arm for your bond and ETF investing. Once you pick the firm you want to move your money to, all you will need to do is complete an easy rollover application form and choose the option for a direct rollover; that means your new firm will contact your old 401(k) directly and get your money moved. Once your IRA is in place, set up an automated monthly investment (from a bank account) for the growth portion of your retirement portfolio. I highly recommend making monthly investments rather than big, once-a-year lump-sum investments. Periodic investments are a way to dollar cost average, a smart investment strategy for stock investing.

ACTION:
When you convert any money into a Roth IRA that was in either a traditional 401(k) or a traditional IRA, you will owe taxes. So you
need to consider carefully how you will come up with the cash to cover a tax bill. One strategy is to convert just a small portion at a time, so you aren’t hit with a staggering tax bill. I also highly recommend you consult a tax advisor with expertise in Roth conversions to make sure you choose a strategy that does not put you in a tax bind.

But here is what you need to understand: The money in your 401(k) is, in most instances, tax-deferred. That means when you eventually withdraw money from it in retirement, it will be taxed at your ordinary income tax rate. If you roll it over into a traditional IRA, the system stays the same for tax purposes.

A Roth IRA is different: You invest money that you have already paid tax on and then in retirement you get to take out all the money in your Roth without paying any tax on it. So the smart thing to do with your 401(k) is to roll it over first into an IRA rollover. Then, depending on how much money you actually have in your IRA rollover, you would either convert it to a Roth IRA little by little or do it all at once. (You also have the option of doing a direct rollover from your traditional 401(k) to a Roth IRA, with tax due on the entire conversion.) Remember, you will owe taxes on whatever amount of money you convert. (The tax on conversions made in the 2010 tax year can be paid over two years.) But if you go through this effort there is a nice payoff: The growth on the
money in your Roth IRA will be tax-free if you leave it untouched until you are 59½ and have owned the Roth for at least five years. You can learn more about Roth conversions at
www.fairmark.com/rothira
.

ACTION:
Beginning in 2010, everyone is allowed to roll over a 401(k) or a traditional IRA into a Roth IRA regardless of income. If you convert in 2010, any tax due on your conversion can be paid over two years. The tax bill for conversions made after 2010 must be paid in one year.

ACTION:
In 2010, the Roth contribution limit is $5,000 if you are under 50 years old; if you are above 50, you can invest up to $6,000. Individuals with modified adjusted gross income below $105,000 and married couples filing a joint tax return with income below $167,000 can invest up to those maximums. Individuals with income between $105,000 and $120,000 and married couples with income between $167,000 and $176,000 can make reduced contributions. Any financial institution that offers Roth IRAs will have an online calculator
or a customer-service representative to help you determine your eligibility.

ACTION:
It’s important to understand that all the money you pull out of your 401(k) (or traditional IRA, for that matter) will be taxed at your ordinary income-tax rate. And given the large deficits our country faces—to say nothing of the large bills for various bailouts and stimulus projects—there is every reason to believe that tax rates are going to be higher in the future, not lower. How do you protect yourself from those higher tax rates? Invest your retirement money in a Roth IRA. If the account has been open for at least five years and you are 59½ when you take it out, it will not be taxed, period. It is far better to pay taxes on your money today so you never have to pay them again. Also, it’s helpful to know that you can always withdraw any money you originally contributed to your Roth at any time, without taxes or penalties, regardless of your age. Only the growth on your contributions must stay in your Roth until you are 59½. At that point, and if the account has been open for at least five years, you’ll be able to withdraw the growth tax-free as well.

Another great benefit of a Roth is that if you do not need to make withdrawals, the IRS will not force you to; you can just leave the money growing and eventually pass it along to your heirs as an amazing tax-free inheritance. That’s quite different from a traditional IRA and 401(k): The IRS insists you start making required minimum distributions no later than the year you turn 70½.

ACTION:
Invest in a traditional (nondeductible) IRA and then convert to a Roth IRA, but only if you are sure you can handle the tax bill due on conversion.

ACTION:
You need a mix of stocks and bonds; the mix is mostly a function of how many years you have until you retire, but I also respect that your “risk tolerance” might affect your decision making. In the questions that follow, I tell you what percentage of stocks and bonds you should have if you are five years from retirement, 10 to 15 years from retirement, or 20 or more years from retirement.

EXCHANGE-TRADED FUNDS (ETFS)
AND NO-LOAD MUTUAL FUNDS:
For your stock holdings, I’d like you to focus on either no-load index mutual funds, ETFs, or high-yielding, dividend-paying stocks. ETFs and no-load mutual funds are the best way to build a diversified portfolio. Each mutual fund or ETF owns dozens and often hundreds of stocks; for those of you who do not have large sums of money ($100,000 or more) to invest, that is a safer way to go than if you put all your money into a few individual stocks
.

BONDS:
I prefer you to invest in individual bonds, rather than bond funds. I’ll explain below
.

ACTION:
If your retirement account offers them, ETFs are the way to go.

Here’s what you need to understand: Mutual funds and ETFs both charge what is known as an annual expense ratio. This is an annual fee that everyone pays, but it is sort of hidden in that you won’t see it deducted from your account as a line-item cost; instead, it is shaved off of your fund’s return. There are no-load index mutual funds that have very low expense ratios—below 0.30%. But ETFs can be even better, with annual expense ratios of as little as 0.07%. I know that sounds like a very small difference, but hey, every penny you keep in your account rather than pay as a fee is money that continues
to grow for your retirement. That’s just one reason why I love ETFs. The one catch with ETFs is that they trade on the stock markets as if they were a stock, so that means you will have to pay a commission to buy and sell ETF shares; when you buy a no-load mutual fund you do not pay a commission. Discount brokerages often charge $10 or so. That’s not a big deal to pay a few times a year, but you sure don’t want to pay that commission if you are making investments every month with small amounts of money (dollar cost averaging). If that’s the case, you are better off putting money in your IRA every month into a money market account and then purchasing your ETFs every three months rather than every month. That way you save on commissions.

ACTION:
A solid long-term strategy for the stock portion of your portfolio is to put 70% of your stock money in a broad U.S. index fund or ETF and 30% in an international stock fund or ETF. The Vanguard Total Stock Market Index fund (VTSMX) and its ETF cousin, the Vanguard Total Stock Market ETF (VTI), are good choices for your U.S. investment. For the international portion, you can opt for the Vanguard Total International Stock Index (VGTSX) or the iShares MSCI EAFE ETF (EFA).

PLEASE NOTE:
If you are currently invested in cash or bonds, and are ready to follow my strategy for owning stocks, don’t rush to move all your money into stocks in one lump sum. I recommend you use the dollar-cost-averaging strategy explained in this chapter and invest equal amounts each month over the next year to move your money slowly into stocks
.

ACTION:
Buy individual bonds if you can, not bond funds.

I prefer bonds to bond funds because with a high-quality bond you know you will get the amount you invested back once the bond matures. For example, if you invest $5,000 in a Treasury note with a five-year maturity, you will get the $5,000 back after the note matures in five years. During the time you own the note, you will also collect a fixed interest for all of those five years. (By the way, a note works just like a bond; it’s just that our Treasury likes to call them notes.) The problem with bond funds is that they do not have a maturity date and their interest rate is not fixed. So you may get back less than what you invested and your interest rate could go down over the years.

I recommend keeping the bond portion of your account in Treasuries and/or CDs if you are in a retirement account, and high-quality general-obligation
municipal bonds outside of a retirement account. As I write this in late 2009, interest rates are very low, so I think it’s wise to stick with notes or bonds that mature in five years or less. In the coming years, we may see higher interest rates, so I don’t want you to lock up your money today for 10 years or longer. Stick with shorter maturities so you can reinvest at what I expect will be higher rates in the future. (If your money is in a 401(k) and you are five years or less from retirement, I think it is best to stick with the stable-value fund or the money market option, rather than the bond fund.)

ACTION:
Ideally, you don’t want to bail out of stocks completely. Let’s review a few important issues. First, any money you know you will need in the next five to 10 years to pay bills does not belong in the stock market. Never has and never will. But just because you are retiring in five years, it doesn’t mean you will need to use all that money immediately, right? Some you will start to use, and the rest you won’t touch for 10 or 20 or even 30 years, given our longer life spans. If that sounds like your situation, I would ask you to think about keeping 25% to 30% or more of your money in stocks even if you are just five years from retirement.

If your issue is that you lost so much money you worry you won’t have enough for retirement and you want to keep what you have safe, then you need to face facts. Moving all your money into a stable-value fund is not the solution. Here’s what you need to do: Delay your retirement for another three years or more. That will give your stocks more time to recover. It will also potentially give you more working years to save more. And most important, it means you delay when you start to need the money; every year you can put off touching your retirement savings is going to be a tremendous help to you.

Now, the one exception here is if in fact you have determined that when you retire you want to use all your Roth IRA money to pay off your mortgage. In that case, you will indeed “need” all your money sooner rather than later. And to repeat myself: Money you know you need within five to 10 years does not belong in stocks. Put it all in your retirement plan’s stable-value fund or money market account.

ACTION:
Keep at least 50% of your money in individual bonds, CDs, or stable-value funds or money market accounts. The absolute best move
when you are nearing retirement is to reduce your risk, and that means moving out of stocks and into bonds. But this only makes sense if your stash at the point you retire is big enough that you can get by on it earning 4% or so a year from bond interest. You need to make sure you have a large enough amount saved up and you have figured your costs correctly to be able to move completely into bonds and live comfortably. It’s also important to realize that even if you retire at 60, there’s a very good chance you will live to be 80 or even 90. So you are asking your retirement fund to support you for 20 or 30 years. The simple math is that if you are making withdrawals from your retirement account each month and your remaining balance is growing at just 4% or so a year, you run the risk that your money will not last 20 or 30 years. (Just about every financial institution has a free online retirement calculator that will estimate how long your money will last. Or type “retirement calculator” into your search engine.) You need to balance the growth potential of stocks with the fact that you will soon be relying on your retirement account to live. A 50-50 mix is a good target for balancing those two different needs.