Are Rewards Cards Really that Rewarding?

I have a huge amount of respect for Dave Ramsey.  I discovered him soon after I moved to Tennessee in 1998.  At that time we had just bought a new Jeep Cherokee and were making car payments.  I also had a couple of credit cards that I was paying off every month, which seemed to be working for me, until it wasn’t.

After I started listening to Dave Ramsey, we started paying off the car faster, paying it off in about three and a half years instead of the original six we were signed up for.   We then refinanced the mortgage from a  30-year to a 15-year, taking advantage of the lower interest rates, then paid if off in about 12 years, saving probably a hundred thousand dollars in interest. Thanks to Dave, we were on great financial footing by the time we reached our mid-thirties, despite starting off “normal,” as Dave would say, which meant that we were in debt with a car payment, spending money as fast as it came in.  (At least we never had credit card debt since we were paying the cards off each month.)

Pick up a copy of Dave’s book if you’re perpetually in debt beyond your mortgage and get started on your debt snowball – it can change your life:

I still held onto the credit cards since they did not seem to be hurting anything and we were getting a little cash back.  One day, however, I opened up a bill and discovered that I had been charged a bunch of interest, basically wiping out the cash back I was getting.  What had happened was that I had written a check for the full amount, something like $1759.65, but had mis-written the line where you write out the amount of the check.  The  box said $1759.65, but the line said “One-thousand fifty-nine and 65/100s.”  I had left out the seven hundred.

I’m sure that the people who received the check noticed the mistake, but didn’t call and tell me, letting me think that I had paid off the balance in full.  The credit card company (Bank of America) decided instead to cash the check for the lesser amount, then charge me for interest for the first month and the next month since I had not paid the amount in full.   Because I had particularly a large balance the next month, the interest came out to several hundred dollars!   At best I was getting a hundred dollars or so a year in rewards.  Needless to say, I was fairly upset.  When the company refused to refund the interest, I cancelled the card, sending in a check large enough to make sure I paid off the balance so that I wouldn’t continue to be hit with interest.

At that point I swore off credit cards, instead using only cash and a debit card for about eight years as Dave Ramsey advised.   Rewards cards were nice for the free stuff, but they’re ready to zing you if you make one mistake.  There is also the danger of purposely letting yourself carry a balance during an emergency event in your life.  Once you fall into that hole, while you think you’ll just pay everything off and be done with debt, things usually just keep happening to make you fall back in.  It is difficult to climb your way out.


A couple of years ago I did get a credit card again, but this time it is on automatic payment from my brokerage account such that they automatically pay it off in full each month.  So far this has mainly worked out, although I am still somewhat leery.  The only thing I don’t like about it is that they wait until the last-minute to pay off the card, allowing the balance to build up as I add charges for the next month, such that the balance can grow with time and even start to threaten to bump the credit limit if I’ve had some big charges.  I go in every so often and make a special payment to send it back to $0 to keep this from happening.

A few days ago, a gentleman from US News and World Report contacted me, saying that they had done a survey and written a piece on rewards cards, including how to select the best ones and how to manage these cards and was wondering if I wanted to include a link to it in my blog.  At first I was a bit leery to reference the report since I certainly don’t want to promote everyone rushing out and loading up on rewards cards since they really can bite you, but I was impressed once I read the piece in that they constantly made the reminder that you really need to pay the balance each month if you want to be “rewarded.”  If you carry a balance, the value of any rewards will quickly be swallowed up by interest payments.  It also does give some good information on how to select the right rewards card for you if you are so inclined.

The U.S. News & World Report’s 2017 rewards credit card survey and guide can be viewed here:

So if you do decide to get a rewards credit card, here are some things that I would suggest to help protect yourself from ending up in a bad place a few years later:

  1.  Make sure you have an emergency fund, meaning 3-6 month’s worth of expenses, saved away in cash to handle the little emergencies that come up.  Having a credit card for an emergency is a bad plan since that is how people often start to get into serious debt.  Instead, have the cash you need to cover things that come up before the next payday.
  2. Have as fool-proof a way as possible to make sure the bill is paid on time each month. Credit card companies purposely make you wait until after a certain day in the month before you can pay the minimum payment to increase the chances that you’ll pay late.  Watch out for their games that are designed to get you paying interest and penalties.  Find as good a method as you can to make sure that bill gets paid on-time (or early) each month.  Some people send in a check or do a transfer as soon as they make a purchase.  Using automated payment seems to be working for me.  
  3. Don’t ever let the teaser rates cause you to decide to carry a balance.  If you are late with a payment for any reason, and sometimes if you are late in paying another card or even your mortgage payment, they can jack your rates up to 30% or more.  Really, they can jack you rate up if Wednesday falls in the middle of the week or if it is hot in the summer.  They have all of the power in that credit card agreement you probably didn’t scan before you signed up.  You can quickly go from being able to easily handle the payments to just scraping by if the interest rates are raised.  There is no reason to carry a balance on a credit card, ever.
  4. Still use cash to help control your spending.   For most people, spending with credit is painless, where paying with cash hurts.  Think about going to Wal-Mart and shelling out ten crisp $20 bills to pay for a cart full of stuff, versus handing over a card and signing a slip.  One really makes you think about the money you’re spending, the other barely registers.  This means that people spend more with plastic than they will with cash, even when using a debit card.  That is why the fast food chains are now taking credit cards even though they pay a fee when they do.  The amount extra that people spend when using plastic more than makes up for the fees.  While your impulse may be to put everything on the card to maximize your rewards, it is still a good idea to use cash for things like dinners out where you may be tempted to blow your budget if you don’t feel a little pain when the bill comes.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Will the Republican Party Be Changed this Time?


I was eight years-old when Ronald Reagan was first elected.  Like Donald Trump, he was an outsider, elected after years of a dismal economy under a President who tried Liberal policy after Liberal policy to fix it, only making.  Like with Donald Trump’s predecessor, many of the actions Reagan’s predecessor was taking were probably keeping the economy in the doldrums.

The effect of President Reagan’s presidency on my generation was enormous.  We saw that the Conservative, free-market principles, really worked.  If you cut taxes, the economy would surge as people worked more.  There were jobs everywhere because light regulations allowed businesses to do productive things instead of fill out reams of paperwork and businesses actually wanted to be located in the US.  We learned that if you gave people the freedom to take care of themselves, they mostly would.

Then came George H.W. Bush.  America returned from an outsider to a party insider.  We then started seeing typical Republican actions – talking about free markets and lower regulations, but not really fighting to reduce regulations and government influence in the markets.  He even reluctantly went along with the Democratic Congress and raised taxes after his famous, “Read my lips” statement in the debate.

Under President Clinton we of course saw taxes raised a great deal and all sorts of new regulations come into play.  We saw something interesting under Clinton, however, largely due to the push from Newt Gingrich and the Republican Congress elected under the Contract with America pledge.  We saw a requirement that those on welfare, who were able, go back to work.  I remember hearing stories of women who had gone into the workforce after knowing only welfare saying that they had dignity for the first time in their lives.  The other thing that was striking was something I didn’t realize until Bill Clinton mentioned it in a speech he was giving at the 2008 Democratic Convention for Barack Obama – that everyone was working in the late 1990s, and the economy was on fire.  I came to realize that a side effect of getting everyone to work is that you have a lot more things being produced, meaning there is more wealth to go around.

With the second George Bush, again we saw the typical Republican talk about free-enterprise but no a lot of fight for free markets.  We even saw regulation of the light bulb – phasing out twenty-five cent incandescent bulbs for $3 CFLs and $10 LEDs.  When the mortgage meltdown came in the end of 2008, rather than seeing the government simply support the money markets and protecting depositors as they could have done, we saw the government bailing out the large banks and insurance companies.  The people who made the bad mistakes kept their companies and their jobs, while the taxpayer was left holding the bag.  This was clearly crony capitalism, not free-enterprise.

Now, like Reagan, we have an outsider.  In fact, Donald Trump is even more of an outsider than Reagan since Ronald Reagan was at least Governor of California before he became President of the United States.  Trump has never held an ected office or even been an officer in the military – a first for America.  Donald Trump talks about using free enterprise principles – low taxes, reducing regulation, reducing the cost to repatriate money from overseas — to help those in America who have been exploited by the Democrats and ignored by the Republicans.  Hopefully he will do as he promises and the Republicans in the House and Senate won’t block him.  And, hopefully,  Republicans will see the support he has gotten despite not being the most elegant speaker or tactful politician and realize that really using free-enterprise principles is the path to a strong economy.  And that is the path to keeping the Presidency.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Teaching Personal Finance in School


A dyed red-haired rapper criticizes the public education system in a viral YouTube video, “Don’t Stay in School“.  Looking back at my education, I remember learning the capitals of the states for no apparent reason.  Other than watching Jeopardy, I’ve never used this information.  Now my children are also learning the capitols, again for no reason.  With search engines this information is even more useless than when I was in school.

If we replace the teaching of useless and pointless things like this, or maybe the learning of the three types of rocks (igneous, sedimentary, and metamorphic), we would have time to teach children a lot of really important things for their lives like personal finance.  Much of the information about personal finance that keeps people from making bad decisions was not taught to their parents, which is one reason we see so many people buying new cars every three years or running up debt on 19% interest credit cards.  Here are some lessons that should be taught in schools instead of, say, the types of clouds.

The rule of 72.  If you take 72 and divide by an interest rate, that will tell you how long it will take an investment to double at that rate.  For example, if you put your money into a CD paying 4% interest, you will double your money about every 72/4 = 15.5 years.  Double that rate to 8% by investing in bonds and you’ll double your money about every 72/8 = nine years.  You get a better return because you’re taking on a little more risk since the bond issuer could default.  Go into stocks, which have a variable return, but one that averages around 12% annualized if you hold them for at least 20 years and you will double your money every six years or so.  If you invest your money for 30 years, $1000 will turn into $4,000 in bank CDs, $8,000 in bonds, and $32,000 in stocks.  That’s something worth learning.

The rule of 72 works the other way as well.  If you are taking out a home mortgage at 8%, you will pay in interest about every nine years about the amount of principle that is not paid off during that time. Because you pay back very little of the principle during the first two-thirds of a mortgage, if you have a $200,000 30-year mortgage, you’ll pay about $160,000 in interest during the first nine years and still owe about $180,000 on the loan, as if your payments just vanished.  Over the life of the loan, you’ll pay about $530,000 for that $200,000 mortgage.  If you use the rule of 72 and assume you’ll owe about the full loan value for the first 18 years and then a little over half of the mortgage value for the last twelve years or so, you would estimate paying $200,000 for the first and second nine-year period, then a little of $100,000 for the last 12 year period, which is pretty close to the $530,000 paid.  If you get a 15-year loan instead, you could estimate about $200,000 for the first nine years and then a bit more than $100,000 for the next six years.  The true amount you’d pay would be about $344,000 – fairly close to your estimate of a bit more than $300,000.

Note if you keep a credit card balance and are paying 15% interest, the rule of 72 tells you that you’ll be paying the full value of the balance in interest every five years.  If you keep a $10,000 balance on your cards, you’ll be paying $10,000 every five years or about $2,000 per year in interest.  That is a paycheck or two for many people, meaning you’re working a month of your life per year just to pay interest on your credit cards.  Maybe if people learned this in school, they would be more leery of whipping out the plastic for a vacation.

The power of extra payments.  And speaking of home mortgages, here’s a little trick that is not taught in school that would be very valuable.  If you look at your mortgage pay-off plan, you can determine how many payments you could remove from the loan by making an extra payment.  For example, in year one of a 30-year loan on $200,000 at 4% interest, you’ll be paying about $3,500 in principle and $8,000 in interest.  Monthly this is about $300 in principle and $670 in interest each month, for a payment of about $970 per month.  If you paid an extra $300 in a month (the amount of the principle paid each month), you would be eliminating one mortgage payment, saving yourself $970.  Pay an extra payment, and you’re eliminating about three payments, or $3,000.  If you make an extra payment during the last year of the loan, you’d only be saving about $60 since at that point your payments are going mainly to principle.  By looking at the amount of principle you are paying off each month, you can see how powerful making extra payments is.  Early in the loan (and the higher the interest rate you’re paying), extra payments are very powerful and well worth the money.  Later on, not so much.  Maybe if people knew this, they would try to hit the loans hard during the first several years and save hundreds of thousands of dollars.  People often get serious about paying off their loan at the end, but by that point, most of the damage has been done any you might be better off to invest the money.

Small amounts add up.  Let’s say you run by Starbucks every working morning and drop $6 on a sugary coffee drink.  If instead you made a cup of coffee at home for essentially free (compared to $6 per cup) and invested the money, you would be investing about $150 per month or $1,800 per year.  Invested in mutual funds, making 10% annualized over 30 years, you’ll have about $330,000.  That is enough to send a child or two (or three) to college.  So, just by changing your morning routine and making expensive coffee drinks an occasional luxury rather than a daily routine, you can pay for college.  Imagine how different things would be if almost everyone did this.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Financial Options for Paying for Retirement


So perhaps you’ve been saving and investing for years, and now retirement is in your sights.  The question now is, “How do I use the money in my retirement accounts and other savings to pay for things in retirement?”  Today I thought I’d discuss some considerations and ideas.

How much income can I receive each month?

The first consideration is how much spending money will you have in retirement.   This information might also point to the need for a part-time job or other source of income in retirement.  A fairly good rule-of thumb is that you can withdraw about 3-4% of your net worth per year from your retirement account without the value declining in value in real-dollar terms.  (Here “real dollar” means dollars adjusted for inflation so that you’ll have the same amount of spending power as the years go on.)  If you withdraw more than this, you will be spending your portfolio over time and eventually run out of money, assuming you live long enough.

For example, let’s say you have a portfolio (401k, IRA, savings, etc…) totaling $750,000.   You would be able to spend about 0.03*750,000 =  $22,500 per year without seeing the value of the portfolio decline and be able to leave your heirs about the same amount of money when you died.  Monthly this would be about $1875.  If you were just paying for a family of two, had the house paid off, drove old cars, and didn’t do much, this might be sufficient.  If you wanted a bit more of a lifestyle, you might need to work a part-time job to help with expenses.  You could also consider options such as selling your home and downsizing to increase the investment portion of your net worth.  If you pulled out $40,000 per year, the value would decline over time, meaning you might run into an issue in your 80’s or 90’s.

How can I generate the income I need?

The second aspect is how you use the money in your portfolio to generate the cash needed to pay for living expenses.  Here there are basically three options:  1)  Invest a portion of the portfolio in income producing assets to generate regular payment, 2) Sell some assets each year to raise cash, and 3) Buy an annuity to pay the income you need.  Let’s look at each of those options.

1.  Invest a portion of the portfolio in income-producing assets to generate income.

This is the traditional way of generating income for expenses.  It works well in times when interest rates are fairly high (not the current period).  Many people simply invested in bank CDs to generate income, but while the dollar value of bank CDs remains constant, value will be lost to inflation each year, plus the rate of return will always be lower than other options like bonds, real estate, and dividend-paying stocks.  You can choose this option if interest rates are sufficiently high to generate the income you’ll need and you’ll have enough left over to invest in growth assets like stocks to prevent inflation from reducing your rate-of-return in the future.

Typically the percentage of income investments when you retire should be around 50%, so if you can generate enough income from bonds and dividend-paying stocks using about half of your portfolio or less, while investing the remainder in growth stocks that will increase in value with time. this could be a good option.  Note that as you age, you would shift a greater percentage of your assets to income assets to increase the amount of income you receive each month to account for inflation.  When you were 80, you might be 70-80% in bonds and 20% in growth stocks.  You could buy individual. stocks and bonds, but it is usually easier to buy an income fund.  Also note that the higher the return you’re receiving, the higher the risk you’re taking.  It is generally a good idea to spread the risk out between safer, lower paying bonds and more risky, higher paying bonds.

2.   Sell some assets each year to raise cash.

The first strategy is probably best if you have just enough money to generate income for retirement.  If you have more than enough, you might still put a portion in bonds to help smooth out the volatility (having about 20% in bonds will greatly reduce the price level of value fluctuations in your portfolio without greatly affecting your total return), but plan on selling assets each year to raise cash for expenses.  Because growth stocks will provide greater returns than bonds and income stocks over long periods of time, this will provide more money to use in retirement and/or pass on to the next generation.  There will be volatility, however, so you need to have enough of a cushion to weather most market downturns that may occur.  This means you really should have at least twice the portfolio value required to generate the income level you really need since a 50% decline in stocks over a short period is not common, but it does happen once-in-a-while.

Part of using this strategy involves using cash to provide the money you need during the years when the market declines and you need to wait for the market to recover before selling more shares.  Since the market usually recovers within a year or less (although there are exceptions like the Great Depression), having a cash cushion will usually provide the time you need to avoid selling shares too cheaply and locking in losses.  Since having a loss over a five-year period is almost unheard of, having between three and five years’ worth of cash is a conservative strategy.  (Note “cash” here means bank CDs and money market funds – not $100’s in your mattress.)

If using this strategy, some level of opportunism should be used.  If there are years when the markets do really well, use the opportunity to raise some cash.  In years when the markets decline, maybe wait to sell unless your cash drops below some threshold, for example, 2 years’ worth of expenses.

3.  Buy and Annuity to provide a monthly payment.

When you buy an annuity, an insurance company invests your money and pays you a guaranteed amount per month for the rest of your life (or some other period depending on the terms of the annuity).  Because the insurance company wants to make money, they will always pay you less than the amount you could have received if you had just invested it yourself using strategies 1 or 2 above.  The difference is that the rate-of-return each year would vary if you invested yourself, where it would be guaranteed (provided the insurance company didn’t default) with the annuity.  The insurance company would get variable returns by investing your money, but make a higher return overall, where you would get a lower, but fixed (guaranteed) return.

Clearly, annuities have drawbacks.  The income they pay is often fixed in dollar terms, so your buying power may decline over the years due to inflation.  If you die young, your money may be gone so you may not have anything to leave heirs.  As stated above, you will not, on average, do as well with an annuity as you will do investing yourself (assuming you invest appropriately).  The exception may be if you live a really long time, but for everyone who lives exceptionally long, someone dies exceptionally early.

If you do choose to buy an annuity, avoid the fancy annuities that promise things like additional returns based on the market performance or other bells and whistles.  Just buy a simple annuity that pays a fixed amount (perhaps indexed to inflation), either immediately or at a certain age (if you’re worried about running out of money late in life) .    If you want to also get some market returns, hold back some cash and invest it yourself outside of the annuity.

Note finally that there is no reason to just choose one of these strategies.  You can mix and match them.  You could buy bonds and income stocks to generate some income, but also sell some stocks to raise cash to supplement what the bonds were paying, particularly in times like now when bonds aren’t paying much.   You could also buy an annuity to pay for something critical like food and basic necessities, then use bonds and growth stock sales to pay for luxuries like travel and home improvements.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Time to Buy Energy?

IMG_0123There are two fundamental strategies to stock selection – growth and value.  With growth you try to find the stocks in companies that are expanding and will continue to do so for many years.  You profit when the company grows and their share price increases along with the growth.  Eventually they’ll also pay a dividend that will increase in value each year, providing income maybe ten to twenty years down the road.

The second type of investing, value investing, involves picking stocks that are beaten down in value, and therefore are cheap compared to where they should be in price.  Generally the best thing to do is to find industries that are out-of-favor and select stocks within that industry, rather than buying individual stocks that are having issues.  If a whole industry is declining, good and bad stocks will all decline in price.  When the industry recovers, so will most of the stocks within that industry.  In fact, the companies that emerge will do better than they were doing during the last boom time since the weaker companies will have vanished, leaving market share for the survivors to grab up.

If an individual stock is falling because of issues at the company, however, there may be systematic issues with the company.  Many of these companies will take years to recover, and may disappear entirely.  One example in my portfolio where this happened was with Pacific Sunwear, which I had bought at $20 per share, then again at $2 per share once the price had dropped, thinking that they were cheap enough to be worth taking the risk  and waiting for a recovery.  In that case they over-expanded and the taste for their products turned.  Since that point the whole company has filed for bankruptcy.  The company had systematic issues that didn’t disappear with a turn in the economy.

Right now an interesting place to be from a value investing standpoint is energy.  I held a few oil and gas companies just when the energy market peaked about a year ago, leading to some big losses.  I mistakenly decided that I wanted a hedge against inflation and energy seem like a good inflation hedge, so I bought in, right near the top.  The price of oil then dropped through the floor, taking many of my investments down 80% or more.

I sold many of the companies I had purchased, such as Oasis Petroleum and Ensco PLC, since I didn’t see them coming back for a long time.   Others, however, like Greenbriar and Cameco, still seemed like good places to be as a long-term investment.   Greenbriar makes rail cars and was doing well during the oil boom because of all the oil that is shipped by rail.  They also have business beyond oil, however, so they should do well in any booming economy where a lot of things are being shipped.  I therefore bought more shares after the fall and plan to sit on them for several years, waiting for the recovery.

Cameco is the world’s largest uranium producer.  They were hurt both by low oil prices and by the Japanese nuclear accident.  Nuclear power, however, is the only currently viable energy source that doesn’t produce carbon dioxide, and with many countries imposing carbon taxes and other measures to reduce CO2 production, nuclear may become much more popular.  I therefore bought more shares of Cameco after the fall.

These are not short-term position.   It takes time for industries to recover.  Over long periods of time, however, mixing in a few value positions with growth positions can pay off well.  We’ll see what happens for me with these two positions.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Good HSA Investing Can Let You Retire Early


If you are fortunate enough to have a Health Savings Account, or HSA, you might be able to retire earlier than a lot of your peers.  Many people have the money to retire by their late fifties, but they hold out a few more years because they’re worried about losing their health insurance before they become eligible for Medicare.  If you invest properly in an HSA starting when you’re young, you might have the cash needed to carry you through to the time you’re eligible for Medicare and beyond, allowing you to retire on your timetable.

This is even assuming Medicare will still be there when you’re ready to retire.  The actuaries for Medicare have been warning for years that the system is running out of money and will either need an infusion from Congress/taxpayers or it will need to start cutting benefits.  This makes even the more reason to beef up your HSA.

So let’s look at the basics of an HSA and then talk about how to contribute and invest in an HSA to have the money you’ll need for medical expenses later in life.

What is an HSA?

A Health Savings Account, or HSA, is a private account that you can use for medical expenses, including paying the doctor, paying for labs and x-rays, and paying for prescription drugs.  You can also use an HSA to pay for COBRA continuation of insurance if you lose a job.  This means that if you are laid off or see your hours drastically cut, you can continue to get the same healthcare insurance for a period of time (currently 18 months, but always check this since it can change) so long as you are willing to pay both your part and the portion your employer was paying before.  So, having a well-funded HSA can help protect you from an unexpected job loss even years before you retire by providing the money needed to pay for COBRA coverage.  Unfortunately, it cannot (at this time) be used to pay for private insurance.

When you use your HSA to pay for qualified medical expenses (things like those listed above), you don’t need to pay taxes on the withdrawals from the HSA.  If you buy other things, you may need to pay some taxes.

Who can start an HSA?

Basically you can start an HSA if you have an employer who provides one, which means that your employer offers a high-deductible health insurance plan option.  The idea is to encourage employees to choose a plan with a high deductible by also having an account from which they can pay for expenses before meeting their deductible.

How does an HSA get funded?

Many employers fund part of the HSA for you as further incentive to choose the option.   In addition, you are able to contribute some of your own money from your paycheck to fund the HSA.  There are limits on how much you can contribute, so check the laws before proceeding.

Why would you want to contribute to an HSA?

If you pay for medical expenses out-of-pocket, you’ll be spending money on which you will have already paid taxes.  You can deduct medical expenses from your taxes, but only above a really high threshold that most people do not meet.  If you instead put the money into an HSA, then pay for medical expenses out of the HSA, you will not pay taxes on the money deposited from the first dollar.  So, if you are in the 15% tax bracket, this is like the government paying for 15% of your medical bills.  In fact, you don’t have to spend the money on medical bills during the year in which you make the contributions to see the savings.  As soon as you put the money into your HSA, you can deduct the contribution from your taxes, while letting the money stay in the HSA until you need it.

Why would you want to invest in an HSA?

In addition not paying taxes on the money you put in, money from interest or capital gains earned inside of the HSA will be tax-free if used on qualified medical expenses.  This means that you can put $2,000 in an HSA today, invest it in stock mutual funds for 20 years, and maybe then have $16,000 or so that you can spend on medical expenses, all tax-free.  Put in $10,000 today and you might have $80,000 later, and so on.  That $10,000 invested in your early twenties for 40 years might provide around $650,000 in your early sixties, which is enough to pay for some significant medical events even without insurance.  Double the amount you contribute and you’ll have over a million dollars available.

And that’s the part that might help you retire early.  If you have enough saved up in an account to self-insure for the unlikely event that you’ll have a major medical event during the three or four years between retirement and Medicare, you may be able to take the risk.  If before you retire the requirement in the Affordable Care Act is repealed that prevents the sale of catastrophic, major medical insurance , that would be even better since then you could buy inexpensive insurance to pay for the unlikely event that a major surgery will be needed and just self-insure for the more minor events.   The nice part about investing money for medical expenses in an HSA instead of just putting money into an IRA for retirement is that you can spend it tax-free on medical expenses before retirement age.  This provides protection and options for you that an IRA will not.

How should you invest the money inside an HSA?

In investing, you need to look at how soon you’ll need the money.  Money you’ll need (or have a reasonable chance of needing) within the next three years or so should be kept in cash.  Money that may be needed in 3-10 years you should be invested in a mix of stocks and bonds.  The higher the percentage of bonds (up to 80%), the more stable your account balance will be but the lower your return.  Money you don’t need for ten, fifteen, or twenty years or more should probably be invested almost entirely in stocks since they’ll offer the best return and protect your money from inflation.

Cash:  So first look at your deductible and multiply by three to estimate how much money you may need to pay out-of-pocket for medical expenses in the next three years.  Then look at your income and free cash flow and decide how much of those expenses you could cover from your paychecks if needed.  Plan to keep the amount beyond what you could cover from your income in cash so that you’ll be ready for near-term medical needs.  For example, if you have a $5,000 deductible and plan to cover $2500 per year from your salary, you’d need to keep 3 x $2500 = $7500 in cash inside the HSA.  For the first couple of years after you open the HSA, you’ll probably just be building up cash.  Investing comes a little later.

Bonds/fixed income assets: Figure out next what your deductible will be for seven years.  When doing this, assume that your deductible will increase by 10% each year for each of those seven years.  For example, if you have a $5,000 deductible now, use that value for the first year, then multiply by 1.1 for each year afterwards to get $5,500, $6050, $6655, $7320, $8052, and $8858, for a total of about $47,500 over the seven-year period.   Plan to keep about half this amount in bonds and the other half in stocks.  This will result in that portion of your portfolio being fairly stable in value while enjoying modest growth.  In years when the market really falls like 2008, this portion of your account may fall about 15% while the stock market as a whole falls 40%.  In years like 2009 when stocks go up 30%, this portion of your portfolio might gain 15-20%.  This will nearly ensure that you’ll be able to generate the cash you’ll need to meet your deductible in the period 3-10 years from now.

For the first ten years or so after you start an HSA,  you’ll probably not have this much to invest.  Just start by building up the amount of cash you’ll need from the section above,  Once you’ve got enough cash, start buying half bonds and income funds/half stocks and growth funds as you contribute more money.  As far as selecting particular funds goes, you’ll want to just buy an income fund that buys the whole market –  all types of bonds and some dividend paying stocks if possible.  For the stock portion, split between funds that invest in large and small caps 50/50 or just buy a whole market stock fund.  When choosing funds, get the ones with the lowest fees you can find.  If you can find passive funds – those that invest based on a strategy rather than hiring managers to choose investments – that is normally the lowest-cost option.

Stocks/growth assets:  Once you’ve invested enough to cover yourself for ten years out, you’re ready to invest any additional funds for long-term growth.  Here you’ll want to buy a mixture of large cap and small cap stocks, while skewing slightly towards small caps.  For example, you could put 40% in a large growth stock fund and 60% in a small growth stock fund.  If you have the option to buy into an REIT fund, which invests in real estate, you could add this to the mix with maybe a 20% REIT, 50% small cap, 30% large cap allocation.

As with everything, this will start slow with only a small amount invested in your HSA.  After sticking to the plan for many years, however, suddenly the value will explode.  You’ll be surprised at how much money your investments are generating and how easy it is to cover your deductible and medical expenses each year.  Before you know it, you’ll have plenty of money to cover medical expenses.  You’ll then have a lot more freedom and a lot more options.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Do Taxes Like Donald Trump

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Much ado was made about Donald Trump’s tax return where he lost close to a billion dollars in one year. The speculation was that he might have not paid taxes for the next 18 years.  The fact is, we really don’t know from that one return whether he paid taxes or not for the next 18 years.  If he made a profit of a billion dollars the next year, he would have been paying taxes from the following year onwards.  He just would be allowed to use the loss in 1995 to offset gains for up to 18 years due to the tax laws.

Unfair?  Unpatriotic?  Hardly.  The issue is that we have an income tax in America, which taxes, well, income.  If you have lots of income, you pay lots of taxes.  If you have little income, you pay little taxes.  People have decided that you should pay more (a greater percentage in taxes) if you make lots of income because 1) you can afford to do so, 2) somehow you are evil and should be punished if you make lots of income, and 3) everyone else deserves some of your money since you make so much.  This is a called a progressive tax code that charges one percentage for the first so many thousand dollars, then a higher percentage for the next so many thousands, and so on.  For those who make a lot of money, they only get something like forty cents for each additional dollar they earn.  Note this probably doesn’t encourage business owners to stay in the office and work a few more hours to open additional factories and create more jobs since they will only get to keep forty cents on the dollar once they reach the income threshold.  This means fewer jobs may be created because of the tax code.  It also really encourages high-income individuals to find ways to pay less in taxes.

Part of the income tax code, because it taxes income, is that you only pay taxes on your net income, when you make income.  Your net income, for an investor, is the amount you gain when you sell stocks or other assets.  You don’t pay taxes while you still own the stocks, buildings, etc…, even if they go up in value during the year, because you don’t have access to the money – it’s only on paper.  At the end of the year you add up all of the gains for the stocks you sold for a gain (those you sold for a higher price than you paid).  You then add up all of the losses from the stocks you sold at a loss (you got less back than you paid).  You subtract the total loss from the total gain, and that is your income – money you have that you didn’t before.  You pay taxes on that amount.  Even if you make a billion dollars on your gains, if you lose a billion dollars on other stocks you sell at a loss in the same year, your net income is zero and you pay no taxes.

For example, let’s say you have 1000 shares of XYZ stock that you bought at $10 a couple of years ago.  You decide to sell the shares because they’re now at $20 per share, making a profit of $10,000.  The same year, you sell 400 shares of ABC stock that you bought at $40 per share, which are now trading at $20 per share, taking a $8,000 loss.  In total, you have made $2,000 because you made $10,000 on one transaction but lost $8,000 on another.  In the end, you have $2,000 more in your pocket, not $10,000.

But let’s say that you had another stock, DEF, and you also had a loss of $10,000 on that stock.  Now you have a net loss for the year of $8,000.  Because you have no income that year, you pay no taxes, as Trump did in 1995.  But let’s say that the next year you sell a stock and make $12,000.  You really have only gained $4,000 since you lost $8,000 the previous year.  It would, therefore, be unfair that you needed to pay taxes on a $12,000 income when you were only $4,000 ahead over the two years.  The tax law, therefore, lets you roll the loss for the previous year forward and use it against the gain you make the next year.  You really only made $4,000, so you only pay taxes on the $4,000 gain.  Trump, therefore, would not need to pay taxes again until he had made at least enough in profits over the next several years to offset the billion dollar loss he took in 1995.  In other words, he did not pay taxes until he actually made income – fair enough.

Trump said that he didn’t pay taxes because he was “smart.”  He was being smart, and you should be too.  Here’s what he probably did, as should any investor:

Note:  This assessment of the tax code is believed to be true at the time this is written.  Before you do anything, verify the following statements against the tax code since things do change or, better yet, check with an accountant.

  1.  When you need to sell stocks to raise money for something, look at your gains and losses.
  2. Try to pair gains and losses together so that they offset each other.  For example, if you need to raise $50,000, and you have a stock worth $25,000 with a $10,000 gain, and you have another stock worth $25,000 with a $11,000 loss, sell them both together in the same tax year.  That way you won’t pay taxes on the gain while you have a big loss sitting in your portfolio.
  3. Remember that you can also deduct up to $3,000 in stock losses against regular income.  In the example above, the extra $1,000 in losses could be deducted from income for the year.
  4. DO NOT sell a stock at a loss and then buy it back within 30 days.  Likewise, don’t sell a stock at a loss if you’ve bought more shares of the same stock within 30 days.  This is called a wash sale, and you probably won’t be able to deduct the loss if you do so.  The same holds true if you buy something “substantially equivalent” to the thing you took the loss on (for example, you take a loss on a Vanguard S&P500 fund and then buy shares in the SPDRs within 30 days).
  5. Note you can take gains and then buy shares back immediately all you want.  You might want to do this if you sell a big loser and have a big gainer in your portfolio that you want to keep.  Sell them together, then buy back the shares of the gainer immediately to reset your cost basis.  Note you could have also rolled the loss forward into future years if you had not sold the gainer, but this might make your taxes simpler to just take the gain and the loss together.

Other smart things to do:

  1.  Put stocks that pay dividends and bonds (which pay interest) into tax deferred or tax-free accounts like IRAs and 401k plans so that the income and dividends won’t be taxed every year.
  2. Fill your taxable accounts with mainly long-term growth stocks (or index funds) which will not generate a lot of income until you sell them.  Note this rule only applies if you do not need current income for expenses.  If you’re living off of your investment account in retirement, it might be better to be living from the income in your taxable account while your 401k continues to grow.

So there you have the secrets of Trump.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

What Effect will a Donald Trump Presidency Have on the Stock Market?

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Wednesday morning, many commentators expected the US stock market to fall through the floor after Donald Trump’s surprise victory.  Their expected moment of schadenfreude, however, quickly evaporated as the stock market opened and proceeded to go…. up!  So, what happened, and what will this mean for the stock market going forward?

Well, the stock market doesn’t like surprises.  The difference in the price of a stock between where it is currently priced and where it should be priced in the future, given predicted future earnings and dividends, reflects the amount of uncertainty that people feel.  If people were certain that Apple was going to pay a certain amount of money out in dividends over the next five years, the stock would go up in price until the return from the dividend was about the same as they could get from a five-year bank CD.  Because they are not certain, however, the price is less than that, to account for the uncertainty in actually getting the return expected.  When they are right, the reward they get is then great enough to make up for the times when they are wrong.  This is called discounting and is done automatically by the auction style of the markets.

When there are surprises, such as when the candidate that was not expected to win, does, this creates uncertainty.  The people who had bought stocks the night before assuming a Clinton win were suddenly faced with a Trump presidency.  They had to step back and reevaluate where stocks should be priced given this new reality.  When they don’t know what to do, the first reaction is to sell off.  They don’t want to pay too much, so they only buy when they are able to pay a lot less than they think stocks are worth.  This was seen in the fall of stock futures Tuesday night.

By the time the market actually opened, however, people had time to digest the new reality had thought about the effects.  They realized that if Trump cuts regulations, as he has said he would do, this would help many businesses since their cost of doing business would decline and less money would be wasted filling out paperwork to meet regulations.  This would also help consumers since the cost of goods and services would decline, so they would have more money to spend and help drive the economy.  Removing the confines of Obamacare, such as requirements that businesses with more than a certain number of full-time employees provide health care, likewise would cause businesses to hire and reinstate many employees who had been moved to part-time to avoid needing to give every health insurance back to full-time status.  This would also be good for the economy.  All of these realizations caused the stock market to rally when it actually opened.

Not every stock did well.  Hospital stocks tended to fall since, without Obamacare, they may see less revenue since people would not be forced to buy insurance and therefore be more reluctant to have medical procedures performed.  Plus, they might see an uptick in the number of people who show up with no insurance that they still need to treat.  Stocks like coal and oil producers did especially well since they were facing some of the most stringent regulations.  Many coal companies were on the brink of going out-of-business.  Banks also did well since they may see some relief from the Dodd-Frank regulations.

So what will be the effect in the future?  All I can say is that the economy will grow, given an environment where it is not overly constrained.  Policies that increase the cost of labor like requiring high minimum wages and having companies be forced to provide certain benefits are hard on workers since they make only the most skilled and efficient employable and drive companies to cut jobs and replace workers with technology, but the economy can still grow.   I can also say that stocks will go up, almost regardless of the environment, since companies find a way to make money – they need to in order to survive.  This is why you should always be invested according to your investment horizon (how long you have to invest) and personal risk tolerance, no matter who is in the White House and no matter what you think about the state of the economy.  The biggest moves up in the stock market happen very suddenly.  You don’t want to be standing on the sidelines when one does.


Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are Pension Plans Good Ways to Save for Retirement? Part 2: The Company Perspective


In the first post in this series, Are Pension Plans Good Ways to Save for Retirement, Part 1, we looked at both pension plans and 401k plans and compared both the benefits and dangers of each.  This time we’ll look at pension plans from a company perspective.

Let’s say that you own a large company and have a pension plan.  Your company has agrees to pay your employees a certain amount per month after they retire until they die based on their years of service and their salary while working for your company.  Some plans also require employees contribute a certain amount of their salary to the plan while others do not.  Because the amount the employee will receive is specified, a traditional pension plan is known as a defined benefit plan.  How would you manage this to make sure you could pay your employees when the time comes?

Well, you would want to let the markets do most of the hard work for you, just as would any investor who was investing for retirement.  You would need to make sure that you had the cash needed for employees who were currently retired or will retire soon, however.  How would you approach this issue?

Well, for the people who were retired or will soon retire, you will have been making contributions for them and possibly been having them contribute for a significant period of time.  You would have invested this money while they were still a couple of decades or more away from retirement so that they money could grow.  The better your investment returns, the less you would need to put into the plan from your business.  Because they would be retiring soon, you would start to transfer the money into cash, buy annuities (that pay a specified payout), and/or move money from stocks to bonds to reduce volatility and start to generate the income you need to make the pension payments.

For the workers who were just starting, you’d know that you had a long time before they are going to retire.  Since you have a long period to wait, you would want to make your investment returns as large as you could while taking reasonable risks.  Remember that if your investments are doing well, it reduces the payments that the company needs to put into the pension plan to keep it solvent.  If investments do badly, however, they might need to add more, so they do not want to take any extreme risks.

How does this compare with a 401k?

Really if you look at the way the pension plan is invested, it is similar to the way that you would invest a 401k.  When workers are young, the company would invest mainly in stocks and other growth assets that can make good returns and that would grow with inflation.  When workers are getting near retirement, the company starts to move money into cash, bonds, and other income investments that are less volatile to reduce the risk that a market move would cause there to be not enough money available to pay the pension payments.

Let’s look at the risks of a 401k versus a pension plan:

Poor Investing:

Pension:  If a company’s investment do poorly, such that the amount of money in the pension plan drops below levels needed for solvency, the company will be required to add more money to make it solvent.  If the company fails, the pension will be covered up to certain limits by the federal government.

401k:  If you invest badly, there is no one to bail you out.  The company provides whatever they are going to provide at the start, and that is all they will provide.

Market event near retirement:

Pension:  The pension manager should be shifting funds needed for near-term retirees to cash, bonds, and other income investments.  As long as this has been done, there should still be money to pay benefits while waiting for the markets to recover.  If the pension manager does a poor job, the company will be required to add more money into the plan or the government will insure the pension up to specific levels.

401K:  The investor should start shifting to income investments and cash as retirement nears to give him/her the ability to pay living expenses while waiting for the markets to recover.  If this is not done, the investor may face difficulties in retirement and run out of cash quickly.  There is no issue if you manage your account correctly (or get good advice from a financial planner), but could be a big one if you do not.

Possible returns:

Pension:  A good pension manager should be leaning towards stocks and growth investments for the portion of the pension plan covering the younger workers, but if they invest too much money in this way and the market falls, the company might be forced to add more money to the pension plan.  Many managers would, therefore, err on the side of caution, reducing risk but also reducing long-term rewards.  Note that since the reward is predefined (you won’t get more money if the pension plan does really well), and because companies would tend to be cautious on what they would provide in the way of returns to make sure they can pay them with a bit of a cushion, possible returns will be lower than market returns.

401k:  Properly invested, choosing growth assets early in career and shifting to income investments late in career, an investor can get better returns with a 401k than with a pension plan.  Investors can also make bad choices, either moving money around, chasing returns, or investing too much in income (or worse, money market funds) early in their career.  A pension manager will probably not make similar mistakes.


Pension:  Should the economy collapse, the investments in the pension plan would be wiped out, as would the company.  It is unlikely that the government, which gets its funds from the economy, would be able to bail anyone out.

401k:  In the event of an economic collapse, 401k funds would be wiped out.  An investor entirely in cash might be able to salvage some value, but inflation would probably quickly wipe out any cash reserves.  Gold would be of little use since people can’t eat gold.

So in conclusion, an investor who invests well in a 401k will probably do better than he/she will with a pension plan.  A pension plan will provide a return below what is possible with a properly invested portfolio, and also tend to be more conservative in how they invest.  The biggest reason that people tend to do better in pension plans than in 401k plans is the employee/investor.  Too many people invest poorly, doing things like leaving all of their money in the money market fund or keeping all of their money in stocks when they are close to retirement.  Even worse, many people take money out of their 401k plans before retirement age – something you can’t do with a pension plan – which means they pay penalties and taxes, miss out on all of the growth they would have gotten near retirement, and spent the money they will need later.  They then say pension plans are bad when they have no money at retirement.  You are your worst enemy.  If you can control yourself and just get a little bit of information on how to invest (or get a good investment advisor), you’ll be better off in a 401k most of the time.

Got an investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Are Pension Plans Good Ways to Save for Retirement? Part 1: Comparing the two plans

Clingdome2I was reading an article from the one percenter on pension plans and thought that more should be said on the subject.  Defined benefit pension plans are often highly coveted, while 401k plans are seen as less generous and risky.  After all, in one case you are guaranteed a certain income or lumped sum, while in the other case your final return will be based on the fickle will of the markets, right?  Well, not exactly.  Let’s look at both plans.

Defined Benefit Pension Plans

As the name implies, a defined benefit plan has a prescribed benefit when you retire.  This benefit is often based on some really complex formulas, but, in theory, with some assumptions and some help from HR you should be able to predict what you’ll receive in retirement because the benefit is defined.  They were designed in the past to keep employees at the same company.   Most defined benefit plans pay you a specified amount based on years of service and your earning level during your highest earning years.  City and state workers are famous for taking advantage of this last factor, working lots of overtime during the last few years to increase their highest earning years, sometimes retiring with a pension that is higher than their salary when they were working.  Most corporate plans, however, base the pension on base salary, not including bonuses or overtime, so this trick will usually not work.

As an example, let’s say a plan will pay you, per year, 2% of the average of your highest three salary years for each year you work during your first 20 years with the company, then 1.5% for each year after that.  Again, this is an example – all plans have different rules.  Let’s say that you work for 40 years with the company and that you earn $69,000, $70,000, and $71,000 during your highest earning years (an average of $70,000).  You would earn 40% of salary for the first 20 years, then 30% of salary for the last 20 years, for a total of 70% of the average of your highest earning years.  When you retired, the pension plan would pay you 70%*$70,000, or $49,000 per year for the rest of your life.  Many plans also have spousal benefits where your spouse would get some portion of your benefits (maybe 50% or 100%) for the rest of his/her life after you died.

As you can tell, one issue with the traditional plan is that when you and your spouse die, your benefits stop.  There is nothing to leave the children.  If you both die a year after retirement, you’ll receive almost nothing in pension benefits.  If you’re lucky and live to be 105, you’ll make out like a bandit. To improve the plan, another benefit that some plans (fewer and fewer) offer is a lump sum payout.  In this scenario the company pays you a lump sum when you retire, usually based on the amount of money you’d need to put into an annuity to receive the same monthly benefits.  This means that the longer an average worker is expected to live, the higher the lumped sum will be, and the higher interest rates are at the time, the lower the benefit.  Many plans also put a cap on how low interest rates can be to keep from giving too large a payout.  In the current low-interest rate environment, many plans are just dumping the lumped sum option entirely since their payouts are getting too large.

A word of caution is needed here.  One of the assumptions needed to predict your benefits at retirement is that the plan will not change.  This can be dangerous since, while employers are required (by law) to pay you what you have earned, they are not required to honor any future increases in your benefits.  This means they can change the plan for future years even after you have started working.  Most employers try to live up to their side of the bargain, but you should not take it for granted that the plan when you turn 65 will be the same as it was when you signed on at 22.  For example, let’s say you worked for 20 years with the pension plan described in the example above.  At that point, the company decides to freeze their pension plan, such that you don’t earn any additional benefits.  Let’s also say that your average salary for the three years before they froze the plan was $40,000 per year.  When you retired, you’d receive 40% of $40,000 per year, or $16,000 per year, instead of the $49,000 you were expecting.  The company is required to pay what you have earned, but can change the rules for future years at any time.

401K (Defined Contribution) Plans

401k plans are defined contribution plans, where the company defines how much they are going to contribute.  Virtually all plans require the employee to contribute a portion of their pay to the plan (some pension plans do as well), and then provide a matching contribution.  For example, it is fairly common to match what an employee contributes up to 5%, such that if the employee puts in 5%, the company also puts in 5%, such that you’re saving 10% of your salary for retirement.  You could contribute more of your pay to the plan, but the company would provide a maximum of 5% of your pay.  For example, if you contributed 10% of your pay, the company would contribute 5%, for a total of 15% of your pay.

Once the company has put in whatever they agree to add, their part is done.  The employee invests the money, using a variety of mutual funds provided by the plan.  At retirement, the employee takes control of the money in the plan and is free to withdraw it or roll it over into another account such as an IRA.  At that point the employee will usually choose to keep the money invested in funds or buy an annuity to provide a pension-like payment each year.  There is no guarantee on how much money will be in the account – hence the term, “defined contribution.”

What are the advantages and dangers of a pension plan?

Advantage:  If nothing is changed, a pension plan has a predictable benefit.

Danger:  That benefit can be changed during the working career of the employee.  Only already earned benefits are guaranteed.

Advantage:  Pension plans are guaranteed by the government if the company pension plan fails.  Companies are also required by law to make contributions to the plan to keep account balances at a specified percentage of benefits owed to help keep the plans from failing.  This means the plan may still be solvent even if the company goes bankrupt.

 Danger:  That guarantee will not necessarily cover your full benefit since there are limits.  If you have a lavish pension plan, your benefits may be cut significantly if the government takes over.  Also, the guarantee will not provide future benefits, just whatever you’d earned when the company failed.

What are the advantages and dangers of a 401k plan?

Advantage:  The money is in an account you control, allowing you to see how much you have and control how it is invested.

Danger:  You’re in control, so there is no backup plan if you invest poorly.  The worst way you can invest is to put it all in the money market fund.  Putting the money into a target-date fund with a date corresponding to when you will retire, if available, or dividing the money into stock and bond funds are both good options.  If choosing the latter option,  a greater percentage should be in stocks when you’re young and about half bonds and half stocks when you’re near retirement age.  A rule-of-thumb is the percent of bonds you own should be equal to your age minus 10.

Advantage:  Every 401k plan is, by definition, a lumped-sum plan.  If you die early, even before you retire, you can leave the plan to a spouse or other heirs.

Danger:  For whatever reason, the government allows people to make withdrawals from their plan before retirement.  Some of these can be without penalty, under special circumstances, but most withdrawals before retirement age come with a 10% penalty, plus normal income tax payments.  Many people ruin their finances in retirement by taking the money out of their 401k early and wasting it.

In the next post, we’ll look at pension plans from a company perspective and see how they compare with a 401k plan.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.