Can You Contribute to an IRA If You Don’t Have a Job?

There is a lot of confusion surrounding the eligibility of contributing to a retirement account. I covered the topics of contributing to an IRA as a teenager and while you are in college.

But what about if you are unemployed? Can you still contribute to a retirement account if you don’t have a job? As with anything related to the tax code, the answer is yes…and no.

contribute to a retirement account

Can You Contribute to a Retirement Account If You Don’t Have a Job?

Can You Contribute to a 401k Without a Job?

No. When it comes to contributing to a 401k plan when you don’t have a job, the answer is no. First of all, an employer needs to sponsor the plan. Therefore, if you don’t currently have a 401k, you cannot open one. That is unless of course you are an employer yourself. But if this were the case, then you would be employed and you would be eligible for a Solo 401k.

But let’s look at a more common situation. You have a 401k at an old employer and you want to contribute to it. Unfortunately, you cannot contribute to the plan since you don’t have a job. In most cases, the old employer won’t let you invest in the 401k plan even if you did have a job. This is one of the reasons why it makes sense to roll over your old 401k plans to either an IRA or your current employer’s 401k plan, if they allow for rollovers.

Can You Contribute to an IRA If You Don’t Have a Job?

Maybe. You have to give it to the tax code because you can contribute to a Traditional or Roth IRA without a job. But you might not be able to either. Sorry, I don’t make up the rules. Let’s first tackle the possibility of contributing to an IRA without a job.

In order to contribute to an IRA in a given year, you need to have earned income. Earned income is income earned from a job, net earnings from self-employment, long term disability benefits and union strike benefits. Interest, dividends, child support, alimony, Social Security benefits, pension income, unemployment benefits and capital gains are not considered earned income and are therefore not eligible.

So let’s say you have earned income earlier this year but you are currently unemployed. The IRA limits state you can contribute 100% or $5,500 whichever is less, in 2013 to a Traditional or Roth IRA. If you earned $2,000 this year, then you can contribute all $2,000 to an IRA, regardless if you are currently employed or not. The key here is that you earned the income in 2013.

If for example, you earned $10,000 this year, the most you can contribute is $5,500. This then takes us to when you cannot contribute to an IRA. Luckily, it is fairly straightforward. If you have no earned income for the year, then you cannot contribute to an IRA this year.

Trouble happens when you enter the next year and have earned income. Let’s look at this situation. Assume you did not work in 2013 and therefore have no earned income. When contributing to an IRA you can contribute to an IRA for 2013 from January 1, 2013 through April 15, 2014. Many people make the mistake of making a 2013 contribution thinking they can use the money they made in the beginning of 2014. This is not the case. You can only contribute to an IRA if you had income for that taxable year, January 1 through December 31.

Spousal IRA

Even with all of that said, there is still one more exception. Again, I apologize, I don’t make the rules. If your filing status is married and file jointly, your spouse can make IRA contributions for both himself or herself and his or her spouse even if the spouse does not work. To qualify the spouse that is making the contribution has to have earned enough income to cover both contributions. This means that if your spouse makes the maximum contribution for both of you, $5,500 then they need to have earned income of at least $11,000 for that year.

Final Thoughts

As I mentioned, when it comes to taxes, there are rules and then there are exceptions to those rules. Unfortunately, many times there are exceptions to those exceptions as well! In a quick summary as to whether or not you can contribute to a retirement account, assuming you are unemployed you:

  • Cannot contribute to a 401k plan regardless.
  • Can contribute to a Traditional/Roth IRA if you had earned income for the given year.
  • Cannot contribute to a Traditional/Roth IRA if you did not have earned income for the given year.
  • Can contribute to a Traditional/Roth IRA regardless if you have earned income if you are married filing jointly and your spouse makes a contribution on your behalf.

I hope this clears up this issue for you. If you have any questions, just ask!

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Can You Contribute to a Roth IRA In College?

The Roth IRA is a great tool for saving for retirement. You can open a Roth IRA as a teenager, as long as you have earned income. You can even use a Roth IRA as an emergency fund since the money you contribute to a Roth IRA can be taken out the account at any time, penalty free.

With all of these great benefits surrounding a Roth IRA, it comes as no surprise that there is also confusion surrounding Roth IRA’s. Many times, people confuse a Roth IRA for a Traditional IRA and vice versa. One question I get all of the time is can I contribute to a Roth IRA while in college or as a student?

courtesy of StockMonkeys.com

Photo Credit: StockMonkeys.com

Can You Contribute to a Roth IRA in College?

The simple answer is yes, as long as you have earned income for the year. Whenever making a contribution to a Roth IRA, you simply need to have earned income. As long as you have this, you can contribute to a Roth IRA for that year.

Of course, if you make too much money you might not be able to contribute to a Roth IRA. But since you are a student, I will assume you aren’t making more than $105,000 this year as a single tax filer.

How Much Can I Contribute?

The Roth IRA contribution limit is the same regardless if you are working full time or part time. The most you can save in a Roth IRA for 2013 is $5,500. Of course, since we are talking tax law, there is an exception to this. Technically speaking you can contribute up to 100% of earned income or $5,500, whichever is less.

For example, let’s say you work full time and go to college part time. You earned $30,000 in 2013. The most you can contribute to your Roth IRA is $5,500.

Let’s say your friend works part time during the summer and attends college full time throughout the year. She earns $3,000 for 2013. In this case, she can contribute $3,000 to her Roth IRA.

Finally, let’s say your other friend goes to school full time and only works a few hours per week at a work study job on campus. Since this income is considered to be earned income, he too can contribute to a Roth IRA. If he makes $500 in 2013 in his work study job, then he can contribute $500 to his Roth IRA.

Final Thoughts

As a college student, saving in a Roth IRA is a great way to get a head start on saving for your retirement and allows for time (who is your best friend when it comes to investing) to work its magic. As long as you have earned income for the year, you can contribute to a Roth IRA.

The only warning I would give is to make sure you have enough money to live on while in college. I know for me personally, my summer job is what I relied on as my “income” throughout my year away at college. I couldn’t afford to use any of it to contribute to a Roth IRA.

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It’s Time to Get Serious About Mutual Fund Fees

Do you know how much you’re paying in fees for your investments? 1%? 2%? It may seem like such a small percentage that you ignore it. Even seemingly small percentages can have a big impact on your investment returns. Here is why you should pay attention to investment fund fees.

Mutual Fund Fees

What are Fees? Fees are the expenses you pay on your investments. There are all different types of investment account fees: loads for funds, payments to an investment advisor, etc. Here I’m primarily discussing the mutual fund fees and investment fund fees companies charge to manage the fund (though the ideas can be applied to any fee you pay to have your money invested).

How do you find out how much your investment fees are? Sometimes you may have to hunt through the prospectus to find the fund management fees for a certain investment. In some cases you may need to contact your employer if it’s for a fund in a 401k. But it’s worth knowing what you are paying for; you would never buy something at a store without knowing exactly what it would cost you.

Expense Ratios. The fund management fees are also included as part of the expense ratio for a fund. An expense ratio includes the management fees and the administrative cost.

Fees Calculated as a Percent on Investments not Earnings

The important thing to remember about these mutual fund fees is that it is a percentage of your investments – not a percentage on your earnings. What does that mean? If you have $10,000 invested in a mutual fund that has a 2% fee then you are paying $200. You pay this $200 regardless of how much you earn on this investment this year. You may earn $0 and you still have to pay the fund management fees.

This may not seem like much but what if you look at it as a percentage of your earnings? What if the fund had a great year and returned 10%? Then you would have made $1,000. Since you’re paying $200 in fees you are paying 20% of your earnings back in fees. (200/1000 = 20%).

What if you didn’t have such a great year and the fund only returned 4%? Then you would have made $400. Now that $200 in fees is half the money you earned.

What if the fund lost money? You’re still paying the fee so that just increases the amount your account goes down.

Of course you don’t write out a check – they simply take it from the account. This sometimes makes it feel like you are not paying these fees but you are just like any other bill.

The Difference Between 1% and 2%

Every fund charges some sort of fee so it can be tempting to think there isn’t much difference between 1% and 2%. If I told you I had 2 cars and one cost $10k and the other cost $20k you’d think there was a pretty big difference. In other words it can be easy to think of the difference between a 1% fee and a 2% fee as pretty small (it’s only 1%) but in reality that 2% fee is DOUBLE. With a 2% fee you are paying twice as much for the fund as a 1% fee. Hopefully it doesn’t seem so small anymore.

What Are You Paying For?

Some funds will say that the reason their fees are higher is that they produce higher than average returns. Of course no one can guarantee such results. The differences are even more apparent for things like index funds. Funds that follow the same index are essentially the same thing. Yet index fund fees vary between companies (sometimes by a lot). Compare your index fund fees to Vanguard fund fees to see the difference.

How High Are Your Fees?

You would never make a major purchase without shopping around and trying to get the best price. Use the same idea when looking at investment fees and it could save you a bundle.

Calculate the fees on your investments. How high are your investment fund fees? What are the expense ratios? For a reference point, Madison maintains a 0.114% expense ratio on her portfolio.

How much are you paying in mutual fund fees?

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Pop Quiz: How Does Volatility Impact Your Returns?

I want to explain to you the impact volatility has on investments. If you are unfamiliar with the term volatility, it can be defined as the fluctuation of value of the underlying asset. A government bond fund is not very volatile. Its price does not swing wildly from one day to the next. On the other hand, a small company international fund, (or emerging markets fund) can be very volatile in price. Over time, this volatility can dictate the return you earn on your investments.

Which Investment Would You Choose?

Below I list two investments and their given return each year for two years. You have $100,000 but can only invest in one of the investments. Which one would you choose?

Volatility1

Many people will see the 50% return in Portfolio #1 and choose that one. After all, a 50% return is much better than a 10% return. Others may see the increase in year one offset by the decrease in year two and think both portfolios have the same return after two years.

Would You Still Choose the Same Investment?

What if I gave you the scenario where you again have $100,000 and after two years of investing, you could have either $75,000 or $99,000. Which one would you choose? I’m hoping most would have picked the $99,000. Would it surprise you that the $99,000 is the value of Portfolio #2 from the example above? The $75,000 is the ending value of Portfolio #1.

The above is the reason why when choosing your investments, volatility matters. When calculating the returns on the above portfolios, both have an average return of 0% for two years. (Average return is calculated by adding up the two years returns and dividing by two). However, when we compound the returns, the return is -13.4% for Portfolio #1 and -0.5% for Portfolio #2. Why is this?

When you have $100,000 and earn a 50% return on your money, you just gained $50,000. If you then lose 50% of your money, you aren’t losing $50,000. You are losing 50% of the current value, $150,000. A 50% loss of $150,000 is $75,000. So while looking at the gain of 50% in year one and a loss of 50% in year two, one would assume that you end up with $100,000. But you don’t. You only have $75,000. The same holds true for Portfolio #2. It looks as though you have $100,000 after two years. But in reality you have $99,000.

How Do You Avoid Volatility?

Unfortunately, you cannot completely avoid volatility. In the short-term, there will be lots of volatility. It’s just the way it is. Over the long-term, volatility tends to lessen, but never truly goes away. But by having a well-diversified portfolio, you can down play stock market volatility. Investing in both an emerging market fund and a bond fund will help to cancel out some of the volatility that you will experience. This lessening of volatility will help you in the long run.

Let’s look again at two portfolios. Portfolio #1 is made up of highly volatile funds, while Portfolio #2 is a well-diversified portfolio. You see the annual returns for each one over the course of ten years. What is the value of $100,000 after ten years?

Volatility2

For Portfolio #1 after ten years, your $100,000 turned into a little more than $96,000. For Portfolio #2, your $100,000 turned into just over $107,000. The point isn’t that the more volatile portfolio has a negative return. It just came out that way after putting the numbers together. The point is that after ten years of emotions that span the entire emotional spectrum from utter despair to exuberance, your $100,000 is still worth roughly $100,000. You could have saved all of that mental energy you wasted over the past ten years on this portfolio and instead invested in the other portfolio. Not only did you end up with a 7% return, you could have focused your mental energy on other areas of your life, such as your family or hobbies.

If we look at the annual returns, you will see what I am talking about. With Portfolio #2, the returns are fairly stable, not deviating too much. Contrast that with Portfolio #1 where it jumps up 30% one year only to fall 25% the next, then jumps back up again. It is basically a roller-coaster. Roller-coasters are great for the amusement park, not so much for investments.

If you are investing for the long-term, to be successful you need to have a well-diversified portfolio. This portfolio will include higher volatility investments. But, as seen in the example above, you can limit some of the volatility over the long-term and experience healthy gains.

Which investment did you choose? Did your answer change after you understood how volatility impacted the overall return?

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Refinancing Rental Property While Rates are Still Low

When I bought my first home, I was excited to take part in the American Dream. Unfortunately for me, this occurred at the peak of the housing bubble. When I purchased my house, I put 10% as a down payment and financed the rest. I thought I was doing a good thing by at least putting some money down. It didn’t matter in the short-term as the bubble burst, so did the value of my house. All told, at the bottom of the bust, I was down close to 25% which I realize is much better than most others.

As the years went on, I continued making my monthly payments, waiting for the time when housing prices would rebound and I would no longer be underwater. As time went on however, I began to focus on something else, the fact that interest rates were extremely low. I locked in my mortgage for 30 years at just over 6%. With current interest rates just under 4%, I could save myself close to $200 per month.

I used the word could in that last sentence for a reason, because I cannot refinance. I ended up moving out of my house and in with my girlfriend, and turning the house into rental property. I didn’t sell the house since it was underwater and I didn’t have the money to pay down the mortgage so that I was no longer under water. Recently, housing prices in my local area have begun to rise. In fact, I am no longer underwater. I owe less than what my house is now worth, but I still cannot refinance.

rental property

Photo Courtesy: Stuart Miles

Refinancing Rental Property

While most people are familiar with the rules for refinancing a primary house, they are much different for rental homes. A lender will be willing to give you a mortgage or refinance your house with little equity. When I still lived in my house and I first explored refinancing, I was told I needed at least 5% equity in the house. The only catch is that I wouldn’t receive the interest rates that are posted everywhere.

The posted interest rates are for those refinancing with 20% equity in their homes. The less equity, the higher risk you are and as a result, the higher your interest rate. To me it didn’t matter because rates had come down so much it still made sense.

But for a rental property, you need to have equity in the rental house. In fact, you need 25-30% equity in the house. Lenders see rental homes as more risky because it is easier for you to walk away and default on the loan. With a primary home, if you walk away, you have nowhere to live. With a rental, this is not the case. As a result, even though I have equity in my home, I cannot refinance until I get closer to the 30% mark.

Can You Use Rental Income to Qualify for the Refinance?

I thought that a way around the 30% equity was to show that I have a tenant and could use their monthly rent to help qualify me for a refinance. While the bank will take into account some of the rental income you earn, it does not make up for the lack of equity. The way rental income helps you if you are buying a rental and the current rent income can be used to “assume” that income will be yours as the new owner. But again, don’t run in thinking that the monthly rent income will be used in its entirety to help you qualify for the loan.

Refinancing Rental Property as a Primary Residence

There is one last point on refinancing a rental property that I need to make. It occurred to me and may have occurred to some of you reading this of a way around the 30% equity. When the lease expires, I could “move back into” my house and complete the refinance then. Since I have equity in my house, I would qualify for a refinance as an owner-occupied house (my primary residence). Then after the refinance is complete, I could move back out and rent the house.

In theory, this sounds like a great plan. But it can be considered fraud. Among the hundreds of documents that you sign at closing will be one that says you intend to live at the house during the loan. Note that the document isn’t indicating that you will always live at the house; otherwise I would be committing fraud now. The document says that you will make a good faith effort to live in the house. Moving in to refinance and then moving out to rent the house is not considered good faith.

Final Thoughts

If you have a house that you are renting out, understand that the same rules for refinancing that property are not the same as the rules for refinancing your primary residence. You need much more equity in the house to even qualify for a loan. I am hoping that I can get enough equity to refinance and lock in a lower rate before interest rates begin to rise.

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Why Do People Invest in Gold?

Gold has plummeted close to 30% in value. Gold was once valued at over $1,700 an ounce but now is sitting at around $1,200 an ounce (as of last week; see the current gold price for today’s gold rate). So what’s the deal with gold? Why do people invest in it and what’s up with the wild price swings recently? My goal is to provide you with a better understanding of gold so that you can be a better investor.

Gold

Photo Courtesy: Boykung

Why Do People Invest in Gold?

For the most part, investors invest in gold for two reasons:

Let’s look into each of these a little more. People buy gold to hedge against inflation. This means that people think that inflation is going to be rising. When inflation rises, you need to earn more return on your money to have the same spending power. Because banks take their time raising interest rates for deposit accounts and the volatility in stocks, people flock to gold. They see it as a safe bet against rising inflation.

The second reason is when banks are paying little to no interest on deposit accounts. Since this has been the case for the past five years, people have been flocking to gold as a possible alternative to low interest rates.

Both of these reasons have occurred since the housing collapse in 2008. Many people feared rapidly rising inflation rates and with interest rates being held down by the Federal Reserve, many investors had nowhere to turn but to gold.

However, there was a third factor at play here. Because of the seriousness of the housing collapse and countries in the European Union teetering on collapse, many feared the world’s financial markets were going to completely collapse. As a result, people invested in physical gold should paper money become obsolete.

All three of these factors helped increase the demand for gold, which drives up the price. But why the sudden drop?

Why Did Gold Drop in Price?

In June, Federal Reserve chairman Ben Bernanke said that the Federal Reserve is going to slowly stop printing money at its current rate, but he didn’t say when this would happen. (A little background here, the Federal Reserve has been printing money and injecting it into the bond market to the tune of $85 billion a month to keep interest rates artificially low. Doing this would hopefully drive people and business to borrow money at super low rates. The downside to this is the belief that it could lead to much higher inflation.)

When Mr. Bernanke said that the Federal Reserve would be slowly cutting back on the printing of money it signaled that the economy was slowly improving and that the fears of rapidly rising inflation were overblown. As a result, those that invested in gold to hedge against inflation had no further need to worry and they sold out.

Why Have Gold?

Back in the day, if you had gold, you were a king or queen. Since gold has a limited supply and is difficult to obtain, those without gold usually remained without gold. But the prospect of obtaining gold and becoming filthy rich is still ingrained in us to this day. I personally question why this is. If the world financial markets were to collapse tomorrow and paper money was worthless, why would I want gold? I would rather have food and water. I would not be interested in trading someone my cow for gold. I would want something meaningful to me in return – food, water, supplies for shelter, etc.

Final Thoughts

Gold is used as hedge against inflation. Why did gold spike and then plummet? It spiked because investors feared the worst – that the global economies were going to collapse from all of the governments printing excess supplies of money. As more and more investors bought into this fear, the price of gold continued to rise. (Up until the bubble started the majority of gold was bought and used in jewelry but by 2009, almost half of all gold was bought by investors. More proof of a bubble: all of the cash for gold advertisements you see everywhere. Remember, you know it’s a bubble when EVERYONE is getting in on it.)  Recently we have seen that their fears were unfounded. As a result many have fled gold, leading it to drop in price dramatically. It’s the classic story of a bubble. Does gold have a place in your portfolio? A small percentage may, but you shouldn’t be selling out of everything and going 100% gold. That plan is simply fool’s gold.

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Should You Reinvest Dividends?

Every quarter some of my stocks pay dividends. Depending on the various mutual funds I own, I receive a dividend from them either quarterly, semi-annually, or annually. I have all of these dividends set to reinvest back into the funds they came from. Why? Because by reinvesting the dividends, I increase the return of those investments.

The Power of Dividends

The chart below explains how this works. If you look at the far right side, you will see the return of the S&P 500 index from 1926-2009. If you add up the blue and gray boxes, you will see that it returned 9.6% annually over that time period. Looking closer you will see that of the 9.6% return, 5.5% is made up of capital appreciation, or increase in the value of the index. The other 4.1% comes from dividends. Over the past 85 years, over 40% of the total return of the S&P 500 Index has come from just dividends!

Looking at the decades presented, you can see varying capital appreciation return and dividend returns. While dividend return makes up less of the overall return in decades where the stock market performed well, such as in the 1950’s, in the 1930’s and 2000’s dividend return helped investors swing losses into break-even situations or even positive returns.

Proof of the Benefit of Reinvesting Dividends

Still think that reinvesting dividends is overrated? Let us say you and a friend each invested $100,000 back in 1926. You did not reinvest dividends while your friend did. What are your investments worth now (using the returns in the chart above)? Your $100,000 grew into $9,472,379 while your friends $100,000 grew to $242,045,550. You read that right, a $230 million dollar difference! I know what you are thinking, so here is another example, a more current one.

We will take $100,000 again with you not reinvesting while your friend does. What does your $100,000 invested in 2000 look like today? You have $72,004 and you friend has $89,719. While you both lost money, your friend lost much less. The reason is because his reinvested dividends increased his returns. Or put another way, offset his losses.

Is Reinvesting Dividends Right for Everyone?

If you are young and are investing for the long-term, you should most certainly be reinvesting the dividends that you receive. Hopefully, the examples above make that clear. But for those readers that are in retirement, reinvesting dividends may not make much sense. For my grandparent’s generation, dividends and bond interest have been a core element to supplementing their retirement income. They built a portfolio of stable, blue-chip companies that pay a nice dividend, along with high quality bonds that pay interest. Throughout their retirement years, they received their dividend and bond interest checks and used it as income, never touching the underlying principal (stock and bonds).

If you are investing for the long term, make it a point to reinvest all of the dividends that you receive. Doing so allows you to purchase more shares and increase your returns as years go by. If you are in retirement, take advantage of dividends and bond interest to supplement your income.

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3 Steps to Successful Investing

It’s all over the news about how the stock market is now trading at all-time highs. For many investors, your portfolios should now be worth more than they were back in 2007 before the financial crisis hit. I say should for two reasons, the first being this assumes you actually stayed invested in the market. The second reason is because many of the investors that I deal with have already recouped their losses from the financial meltdown, and they did so back in 2011. You may be asking how this is possible and what sorts of tricks were used to achieve this. The truth is there are no tricks. It was done by doing what any investor should do that wants to be successful when investing in the stock market.

courtesy of worradmu

Photo Courtesy: worradmu

Diversify

On order to be successful when investing you need to diversify. This is where the old saying “don’t put all of your eggs in one basket” comes into play. You need an asset allocation with a healthy mix of stocks, bonds, real estate and commodities. From there, you need to break down the asset classes further into small and large cap stocks, and domestic and international stocks. As most of you know, the reason for this is because many times, when one asset class is declining, another is rising. This offsets your losses. For help with creating portfolios, I highly recommend Paul Merriam’s book, “Live it Up Without Outliving Your Money”. It’s a short read and he creates portfolios that you can use.

Rebalance

Rebalaning, by some experts gets a bad rap. If you do it too often, it can backfire against you (don’t worry, I won’t go into the heavily technical reasons why). You should look to rebalance annually. I say look because you won’t always have to rebalance. You should only do so if your investments stray by 5% or more from their targets. By rebalancing, you ensure that you are always in-line with regards to your risk tolerance and you will also ensure that you buy low and sell high. The reasons for this are clear:

On the topic of risk, if you take on more much risk than you want, you could set yourself up for losing more money than you wanted it. On the flip side, if you take on too little risk, you might not have enough assets to last you through retirement.

When it comes to buying low and selling high, rebalancing forces you to sell your positions that have risen in value (sell high) and buying those that have decreased in value (buying low).

Read more: Should You Rebalance Your Portfolio or Let it Ride?

Stay the Course

It is very important to stay invested in the market at all times. Trying to time the market by buying in and selling out does not work. Recent studies show that the average investor, one that is constantly in and out of the market, earned 2.3% over the last 20 years. Had you just invested in the S&P 500 you would have earned close to 8%.

Let me say this again: you cannot time the market! No one knows what is going to happen in the market. If someone says they do, ask to see their bank account because it better have gazillions of dollars in it. Think about it, if someone says they know that the market is going to rise or fall on certain day, wouldn’t they use every cent they could get their hands on and put it in the market to make more money? I know I would.

I realize that this step is not very easy with all of the media coverage blowing issues out of proportion. But you have to do your best to ignore it. Turn the channel or go for a walk. Do anything that will get your mind off of the movement in the markets. The less you hear the noise, the less you will worry about it or be inclined to take action. Many investors that sold out of the market in 2008 never came back in and have missed this great run up in prices. Some of those that did enter back into the market sold out at the end of 2012 because of the fiscal cliff fiasco. What happened since? The market kept rising. This isn’t to say the market is going to continue to rise, but to show you that we have no clue where the market is headed. Don’t trust anyone that tells you otherwise.

Final Thoughts

If you follow these 3 steps, you will be ahead of the majority of investors out there. You may not be able to retire tomorrow if you follow these steps, but it will put you in a much better financial situation if you do. As I pointed out, some of these are easier said than done. But do your best to stick with the plan so that you can realize your financial dreams.

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Is Your 401k Plan Disclosing Fees?

Back in January of 2012, I wrote an article on the upcoming fee disclosure rules for 401k accounts. Plan providers were now being required to display how much in fees the employees were paying with their current 401k plan. This is an issue because up until the rule change, providers could essentially charge anything they wanted and never had to disclose it. While you would think that they could not charge too much because people would run, that is not the case with 401k plans.

courtesy of tax credits

Photo Courtesy: Tax credits

401k Fee Disclosure

The reasons for this are two-fold. First, those fees were never shown to employees. The fee was built into the offered funds returns. Think about this: how many times have you heard someone tell you that their 401k plan stinks? The market returns 12% and their funds only return 7%? While not all of the difference is because a high plan fees, a portion of it is. For all you know, you could be paying 3-5% in fees without knowing it. Trust me, I’ve broken out the fees before for some 401k plans and didn’t believe how high the fees were myself. I thought I made a math error. Unfortunately I didn’t.

The second issue a 401k plan isn’t changed is because of the time it takes to change a plan. If Joe employee isn’t happy and complains, the employer isn’t going to change the plan. After all, one employee out of hundreds or thousands isn’t enough to make the employee research alternative plans, interview them, schedule presentations, pick the new provider and then work with them to transition the employees over and deal with any issues.

New Regulation

The new law went into effect this past summer and employees received their first disclosures about the new law and what to expect. Now employees are getting their new 401k statements that itemize the fees that are deducted from their plans. What investors will find will be disappointing. The reason for this is because many 401k plans took the easy road. They didn’t spell out “you paid X% in fees”, but instead displayed a range of fees, as in “your expenses range from X% to X%”.  This leaves employees and employers questioning what exactly they pay in fees.

On top of this, there is no average fee listed. This is important because if I told you that your expenses were 0.50% you are either thrilled because that appears to be a low number, or you are clueless because you have no idea how that ranks compared to other plans.

Now, in defense of the 401k plans, they did follow what the law called for. The law said nothing about providing an average as I mentioned above. And to further defend them, doing so would be hard because of all of the variables that are involved with coming up with such a fee: plan size, number of participants, type of investments, etc.

Future Regulation

As disappointed as I am with how the new law turned out, I am hoping that regulators learn from these short-comings and revise the law to strengthen it. They should require a specific number on how much of a fee was paid as opposed to a range of fees. I would also like to see an average so employees and employers have an idea of what they pay compares to their peers. However, I do admit doing this would be difficult.

What are your thoughts on the new 401k plan disclosures? Do you think they are helpful at all? Do you care if expenses are broken out?

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Alternative to Becoming a Landlord

There is a lot of talk about buying investment properties with housing prices still recovering from the housing bust. Buying an investment property can be an exciting and fun challenge (and more work than you think!). While most will focus on how much money they will make each month from the renter, you have to also consider any possible headaches that might arise as well.

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Photo Courtesy: Renjith Krishnan

Being a Landlord

Currently, I am a landlord. I’ve always wanted to try this out and because of my circumstances, here I am. I bought my house just before the bubble popped, meaning I bought at the peak. Fast forward a few years and my girlfriend and I are discussing moving in together. Because of the locations of our houses, her house made more sense for both of us to live in. I was then faced with the decision of selling or renting my house. The decision for me was actually fairly easy: my house was underwater (worth less than my mortgage) and I didn’t have the cash to fix the situation. So, renting my house became my choice.

So far, I have had nothing but great things to say about being a landlord. My tenant is great and takes care of the house almost as well as I did. Finding her wasn’t easy. It took me a handful of ads and meeting of potential tenants before she found me.

I have had the fridge break down in the house, which was not fun replacing, but it is part of being a landlord. One aspect of my situation that is nice is that my house is in a condo development. As a result, if any emergencies occur, my tenant is to call the management office first, and then call me. This is nice because they will handle many of the larger issues that might arise. This allows me to slowly become acclimated with being a landlord as opposed to jumping into the fire. Of course, for this “service” I pay a home owner’s association fee which makes my profit margin non-existent.

Overall though, it has been a great experience and one that I look forward to replicating in the near term.

But not all landlord stories are as good as mine. There are some horrible stories out there. When I spoke to my attorney about renting, he instructed me to watch Pacific Heights. He said if I am OK taking the chance of renting to this person, then I should become a landlord. He did say that there is only a 10% chance of this happening, but it is a possibility.

Note that you can always hire a property manager to handle the finding of tenants, screening, collecting of rent, etc. But you are still going to be involved in with the rental. I feel that just starting out, you should try to do it on your own as opposed to hiring a property manager as this is the best way to learn and to not make the same mistakes twice.

Alternative to Landlords

If you don’t think that becoming a landlord is right for you, or you just don’t want to own an investment property can you still partake in investment property? The answer is yes!

Instead of buying a duplex or apartment building you can just invest in real estate investment trusts (REITs). These are publicly traded companies that acquire buildings and then rent them out to tenants. By law, for a company to be considered a REIT, they have to pay out at least 90% of their taxable income to shareholders. If you were to invest in a REIT, you would get a payment, usually a quarterly dividend that represented your ownership in the REIT after all expenses were paid.

The key difference between buying a house and renting it and investing in a REIT is this: you are renting a house to person, while REITs purchase shopping malls, warehouses, hospitals, office buildings, apartment buildings, hotels, and even timberlands.

It will be much harder get rich off of investing in REITs. This is because you are a shareholder along with hundreds or thousands of other investors. Your investment in a REIT is a small percentage, whereas your ownership in a rental property is the equity in the property, which over time will grow into 100% ownership. While you own 100% of the property, you will still be collecting a monthly income less taxes.

Another downside to investing in REITs is selling. When you sell your REIT shares, you will get your investment back plus or minus and share appreciation. When you sell your investment property, you will get the equity in the property. Of course you will have to pay taxes on this money, but in most cases, the amount of money will be much more than if you had invested in REITs instead.

There are plenty of advantages to investing in REITs however. The biggest is the lack of time commitment. Once you research and invest in a REIT, you can sit back and do absolutely nothing. This is not the case with buying an investment property. You have to prepare it for renting, find tenants, collect rent, and respond to and maintenance issues.

Another benefit is diversification. When buying shares in a REIT, you are immediately diversified. You own a handful of real estate properties, ideally spread out throughout the country. As we all know, real estate is regional. Once region could be seeing big price gains while another might be stagnant. When you buy an investment property, you only have that one property and the risk is what happens in that local market.

Final Thoughts

There are advantages and disadvantages to both owning rental property and owning shares in a REIT. At the end of the day, you have to decide what works best for you. If you don’t have much free time, or a large sum of money for a down payment, owning REITs might be your solution. Only you can decide how comfortable you will be dealing with tenants. The good news is that even if you want nothing to do with tenants, you can still be active in the real estate market.

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