Thinking back to my teenage days, all I was concerned about was finishing up work at my weekend job so I could drive around and hang out with my friends. I never thought about opening a Roth IRA for teens! The money I made while I worked part-time put gas in the car and provided me some spending money. I was lucky in that I drove my parent’s car and they took care of insurance and maintenance so I only had to worry about keeping the tank full. The last thing that was on my mind was saving for retirement. But now that I am older and wiser, I wish I would have started to put some money away for retirement back then. The reason isn’t only because of the benefit of time, though that is the primary reason. There are many other great reasons to start a Roth IRA for kids.

Photo courtesy of StockMonkeys.com

Decades of Compounding

The power of compound interest is known by many. But just to illustrate it, let’s say you contribute $2,000 per year into a Roth IRA for four of your teenage years. If you make no more contributions and it grows at 8% per year, the account will be worth over $450,000 come retirement. That $8,000 investment grew to near half a million dollars! Of course as you continue to invest in the account, the value as you near retirement will be even higher.

Roth IRA Requirements

Here are the requirements for your teen to open a Roth IRA:

• Income Requirements. Note that in order to contribute to a Roth IRA, your teen needs to have earned income. This does not include any allowance you may pay him or her. They need to have an actual job or earnings from self-employment.
• Contribution Limits. The Roth IRA Limits are $5,000 for 2012 and $5,500 for 2013. Your teen can only contribute as much as they earn, so total contributions cannot exceed earned income for the year.
• Minimum Age. There is no minimum age to open a Roth IRA.
• Contribution Deadlines. The deadline for Roth IRA contributions is the same as the tax deadline. The deadline for 2012 IRA contributions is April 15, 2013. You can open a Roth IRA for teens at any of the various online brokers.

Teaches Kids about Investing

There are numerous stories about how the younger generation is scared of investing in the stock market. Just as bad, personal finance is not taught in schools. So unless you teach your kids about money and investing, their first exposure to it will be when they are signing up for their 401(k) at their first job out of college. Many times they will put off saving then too. By the time they get around to it, they are 30 years old and wasted 15 years of compounding interest. When you take the time to teach kids about money and investing in their teens, they will be years ahead of others not just in terms of knowledge but also with money as well.

Match their contribution. You can even teach them about the benefit of the company match with their future 401(k). Let’s say your teen earned $1,000 this year. You could require her to save $500 in her Roth IRA and you will match it with another $500.

Nest Egg for a House

While I don’t encourage this option be used, it is an option nonetheless. You can withdraw money from a Roth IRA before you reach retirement age to purchase or remodel your house if you qualify as a first-time homebuyer. The reason I am against this potion is because I view your retirement accounts for just that, retirement. Your emergency savings account should be for emergencies, not for the new pair of jeans. Once you begin to gray the line of what the money in the account is for is when you start to get into trouble.

Money for an Emergency

Just like I don’t encourage the option for buying a house above, I don’t encourage using your Roth IRA for emergencies. However, the provision is there that you can withdraw contributions you make into the Roth IRA at any time without paying tax or a penalty. Note that this only applies to contributions, not earnings.

If you saved $1,000 in your Roth IRA and withdrew that $1,000 then no penalty is owed. However, if that $1,000 grew to $1,500 and you withdrew all of them money, you would owe tax and a penalty on the $500 in earnings.

Final Thoughts

While saving for retirement when you are in your teens is not your top priority (OK, it’s probably not even in the top 50), doing so teaches you very valuable lessons about money, investing and personal finance as a whole. I encourage you if you are a teen reading this or a parent of a teenager to look into opening a Roth IRA for your teen. I know it is hard with college costs right around the corner, but the investment pays off substantially in the long run.

See an example of a teen opening a Roth IRA. She used Scottrade to open the account.

What are other benefits to opening a Roth IRA for your teen? What drawbacks do you see?

More For Kids

• 10 Ways to Lower Your Taxes with Kids
• Do Your Kids Need to File Taxes?
• Claiming Dependents on Your Tax Return
• Roth IRA Q & A
• 11 Unusual Roth IRA Strategies

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It’s a new year, so that means most people will be making an annual list of resolutions. These typically range from paying off debt to saving more, losing weight and building better relationships. Pretty much anything you want to change can be included as a resolution for the new year.

There is only one problem with these resolutions: we typically fail at them. It’s not from trying. We all start out of the gate strong, determined to meet that goal. But somewhere along the way, we lose sight of it or get distracted by life and we slip up momentarily. Some of us are able to right the ship, but for many others, that first slip up is an indication of a steep slope up ahead.

Photo courtesy ahisgett

To help you keep momentum and motivation high, I list a few quick and easy financial goals for you to complete. All of them will only take you 10 minutes of your time but will pay big dividends in the long run. So without further ado….

Increase Your 401k Withholding

Simply walk down to your human resources department or email them for the form to increase the amount that is taken out of your paycheck each pay period and goes into your 401(k) or Roth 401k. I’m not asking you to get crazy with the new withholding amount, in fact I am only asking you to raise it 1%. That’s it. If you were withholding 5% increase it to 6%. Of course if you want to increase it more, I am not going to stop you.

Because your 401(k) contribution is taken out of your paycheck before taxes, your paycheck actually decreases by less than the amount you took out. Here is an example for better understanding. Let’s say you earn $25,000 per year and are in the 25% tax bracket. If you contribute 3% of your bi-weekly pay to your 401(k) that comes to $29. So, each paycheck you receive, $29 is taken out and placed into your 401(k). But, your paycheck is only reduced by $22 each time. This is because you aren’t taxed on your 401(k) contribution so it “looks” like you are earning less than you are to the IRS.

If you received any sort of a raise for the year, you will not even notice this extra 1% being removed from your paycheck. And I’ll bet that even if you didn’t receive a raise, you could still increase your withholding 1% and not notice it. Give it a try for a few weeks. You’ll be surprised. If you don’t think increasing your contribution by 1% matters, read my previous post on how much increasing your savings by 1% changes your finances.

Review Your 401(k) Fees

While you are at the human resources department, or within the same email you send them, ask for the enrollment booklet they provided to you when you first started. In the booklet will be a fact sheet for each mutual fund you can invest in that is in your 401(k) plan. Identify the funds you are currently in and note the expense ratio of them. If any of them are high – 1% or more, consider looking at dumping them for other low cost funds in your plan. Unfortunately for many of you, this will not be as easy as it sounds. Most of you are tied to a few funds and most probably have high expense ratios. My suggestion is to look at all of the fund choices and strike out any that have expenses over 1%. Hopefully there are a few funds left. In the worst case scenario, you should hopefully have left on the list of possible investments a bond fund and a large cap fund. Pick these two funds and invest 60% in the large cap fund and 40% in the bond fund (unless the risk questionnaire you completed says otherwise). That’s it. You don’t need to invest in all of the choices. You can use your Roth IRA and taxable account to round out your diversification (yes, you can have a 401k and an IRA at the same time).

Paying attention to fund fees is one of the things that you can control when you invest in the stock market. While it doesn’t seem like investing in a fund that charges 1.25% would cost you that much more than an equivalent fund that charges 0.25%, it does. Refer back to the link above about saving 1% more each year. The difference in saving 1% each year is the same as paying 1% more each year. It adds up to a lot of money over time. And don’t listen to those that try to tell you a fund that charges a higher fee is a better fund or will return more over time. It won’t. It just means you’ll be paying more for it.

Final Thoughts

These are two quick and easy steps you can take in the new year to increase your motivation for meeting the rest of your new year’s resolutions. Again, they will only take you about 10 minutes each, less if you can access your 401(k) online, and will better your future financial state of affairs. Don’t dismiss how big of an impact increasing your withholding 1% per year or paying 1% less in expenses has on your portfolio 10, 30 or 30 years into the future. Little amounts add up over time. Take advantage of this time by saving as much as you can and by paying as little as you can in fees.

Lastly, here is a bonus tip to save you time come next year: when you are increasing your withholding by 1%, see if you can set it up so that come January of each year, you increase your withholding by 1%. This way you never have to think about it or remind yourself to do it. You will always be saving more each year which means your money can compound upon itself even more each year. Before long you’ll reach the 401k limits. If you can’t set this up automatically, then just set an Outlook reminder at the start of each year so you know to increase your withholding another 1% come the new year.

Do you have any additional easy retirement or financial goals for others?

More Retirement Planning Topics

• To Roth 401k or Not to Roth 401k?
• Take Advantage of Retirement Catch-Up Contributions
• 401k and IRA Limits
• 7 Moves You Haven’t Made in Your 401k
• 3 Free Retirement Calculators You Should Try Right Now

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Just about every news story now talks about the fiscal cliff we are headed for. Overall, the fiscal cliff is a combination of the expiring Bush tax cuts, which will raise rates for all taxpayers, along with the start of the taxes we will pay due to the implementation of the Affordable Care Act, commonly referred to as Obamacare. Combine this with a push to cut back on spending and possibly raising taxes even higher on the wealthy, one can see why the media is calling this a fiscal cliff.

Update: Stay tuned for additional details from the Fiscal Cliff Deal in process.

Photo courtesy of Scarto

What is The Fiscal Cliff?

The term fiscal cliff is all over the news these days. The problem is that many do not understand what all entails the “fiscal cliff”. Overall, the “fiscal cliff” refers to a myriad of tax changes that all go into effect beginning January 1, 2013. Among the highlights:

• The end of the “payroll tax holiday” that workers have enjoyed for the past two-plus years. While some call this a tax increase, it really restores the Social Security payroll tax from the current rate of 4.2% to 6.2%.

• The end of the Bush tax cuts will cause tax rates to increase. Gone will be the 10% tax bracket. The highest bracket will go from 35% to 39.6%. Not only will the tax rates rise, but the child tax credit will be reduced while personal exemptions and itemized deductions will be phased out based on income. Also impacted will be the estate and gift taxes.

• The implementation of the 3.8% Affordable Care Act tax on investment income for taxpayers married filing jointly who earn more than $250,000 and for single taxpayers who earn more than $200,000.

• Stiff budget cuts to defense and Medicare, among other programs.

• If no deal is made, fixes made to the Alternative Minimum Tax (AMT) to reduce the effects of the marriage penalty will go away. This is important because currently 4 million taxpayers are subject to AMT. Without continuing the fix, 32 million will be impacted by AMT. For example, right now taxpayers married filing jointly that earn more than $75,000 per year could be subject to the AMT. If the fix goes away, those earning just $45,000 could be impacted. Same goes for single taxpayers. Currently those earning above $48,000 could be subject to AMT and if no fix occurs, those earning just $33,000 could be subject to the tax. On average, those impacted by the AMT could see their tax liability increase by $4,000.

Why The Fiscal Cliff is in the News

Obviously, these tax changes are going to impact everyone, not just those earning $200,000/$250,000 that everyone is talking about. It’s important for everyone to know that they can be impacted by the fiscal cliff. The news is focusing on the effects of higher taxes on high wage earners and not focusing on the other specifics of the fiscal cliff. Be certain to follow the developments so that you won’t be surprised by the new taxes.

How Will The Fiscal Cliff Impact You?

Most readers will feel the sting of higher taxes, both through the end of the payroll tax holiday and the increased federal income tax brackets. These will both be felt with your first paycheck of 2013. The other changes won’t be felt until you file your 2013 tax return.

Because of the higher taxes, many are focusing on finding ways to lower their future taxes now. My advice for those worried about the new taxes is to take a step back before acting and assess the entire situation.

Step, Don’t Leap

When it comes to higher taxes on your investments, probably the most important thing of all is to step and not leap into making drastic changes to your portfolio. Why? Because no one knows how this is all going to play out. Sure, you might be able to say with 90% certainty that taxes will rise, but how sure are you that there won’t be a special provision in the tax code that allows for an extra deduction for you? You can’t unequivocally say for sure what taxes will look like come January 1, 2013. So why completely change everything you have been doing because of a feeling? That is the exact opposite of what you should be doing.

You should have a well-thought out financial plan that you follow. Once you let your emotions creep into your investment decision making is when you start to lose. And having a feeling about where taxes are going to be is just that, a feeling. This is not to say you shouldn’t do anything. You can take some capital gains off of the table or hold off on making a charitable deduction until next year if you think taxes will be higher. But don’t sell all of your holdings or put off all charitable deductions until next year thinking that you can use them to offset the higher tax rate. After all, what if there is a limitation on charitable deductions? You just cost yourself this year and next year by paying higher taxes all because of a feeling.

Same goes for your investments. Don’t sell out of all your dividend paying holdings because you don’t want to pay a higher tax on dividends. Research new strategies for dealing with higher dividend rates now so that when rates go higher you will be able to make a sound decision that makes sense for you and still keeps you within your plan. If you don’t come up with a solution right away, all hope is not lost. You can easily make changes early enough in the new year so that you aren’t hit by higher investment income for the entire year.

Think back to times when you made decisions based on emotion. You know they did not end well. This is the same thing. The worst time to make important decisions is when you are in an emotional state and when things are not clear. Stop, step back and see where things are going before you react. It’s good to be proactive and this is no exception, but be proactive by taking a step, not a leap.

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Now that the Supreme Court has upheld Obamacare and President Obama won re-election, it is certain that come January 1, 2013, many Americans will face new taxes. The press is focusing on one aspect of the new taxes that will help pay for Obamacare, the 3.8% investment tax. But there are many other changes to the tax code because of Obamacare that the press isn’t focusing on. I will do my best to keep things simple, which is hard because well, we’re talking about the tax code here!

New 3.8% Investment Tax

The 3.8% tax increase will be on investment income, which includes capital gains and dividends, for filers married filing jointly earning over $250,000 per year and for single filers earning over $200,000 per year.

Remember that is applies to investment income, not wages. So if you are a single filer that earns $300,000 but have no dividends or capital gains during the year, then the tax does not apply to you. However (and this is typical tax law), wages and Social Security can raise your adjusted gross income making you vulnerable to the tax.

For example, let us say that a married couple filing jointly has earnings of $230,000 plus $170,000 of investment income. While their investment income is below the $250,000 threshold, they still owe the 3.8% tax. Their adjusted gross income is $400,000 which is $150,000 above the threshold. This $150,000 is subject to the 3.8% tax which would be $5,700.

As another example, let us say that you are a single filer that has no wages, but you receive $30,000 in Social Security and have $100,000 in investment income. You do not owe the additional 3.8% tax because your adjusted gross income is less than the $200,000 threshold.

This 3.8% tax will be added to whatever tax rates are in 2013, given that the Bush tax cuts are set to expire at the end of 2012.

What is Investment Income?

Before diving into the other taxes that will come about from Obamacare, we need to define what is considered to be investment income. As it stands now, the definition of investment income includes:

• Dividends
• Short and long-term capital gains
• Royalties
• Interest (except municipal bond interest)
• Taxable portions of annuity payments
• Income from the gain of selling your house
• Net gain from selling a second house
• Passive income from real estate investments where the taxpayer does not actively participate

Note that the tax on the gain of the sale of your primary residence is only on the gain above what is in the books for excludable income. Currently these amounts are $250,000 for single filers and $500,000 for joint filers. This means that if you are single, you would only owe the 3.8% investment tax on gains greater than $250,000. For married filing jointly the tax only applies to gains greater than $500,000.

0.9% Medicare Surtax

The Medicare tax that is deducted from your paycheck will also increase for those married filing jointly whose earnings are $250,000 and higher and single filers whose earnings are $200,000 and higher. Currently, as an employee, you a pay 1.45% Medicare tax, regardless of your earnings. As of January 1, 2013, you will now pay 2.35% on earnings above $250,000 for joint filers and $200,000 for single filers.

For example, if you are married filing jointly and your earnings are $300,000, you will owe 1.45% on the entire amount, which is $4,350. You will then owe an additional 0.9% on the $50,000 above $250,000 which comes to $450.

If you are self-employed, there is no deduction allowable on this new tax, meaning you will be paying it.

Other New Taxes from Obamacare

As I mentioned before, there are many other new taxes or changes to current tax law to help pay for Obamacare. Everyone is subject to these taxes, regardless of your income. Here is a highlighted listing of some of the one’s I feel deserve the most attention.

• The Medicine Cabinet Tax: This tax went into effect in 2011 and excludes the reimbursement of over-the-counter medication expenses from your health savings account (HSA), flexible spending account (FSA) or health reimbursement account (HRA).

• There is also now a cap on the amount of money you can place into a flexible spending account (FSA). The new maximum amount you can contribute to your FSA in 2013 is $2,500. While this does not seem like a big deal, many families use the money in an FSA for their special-needs child to help cover the cost of education.

• In previous years, you could itemize your medical expenses if they exceeded 7.5% of adjusted gross income. They must now exceed 10% of your adjusted gross income if you want to itemize.

• The penalty on non-medical withdrawals from a health savings account will double from 10% to 20%.

• There will be a 2.3% tax on medical devices that cost more than $100 in 2013. While this 2.3% tax will be paid by medical device manufacturers, you can be certain that they will be passing on either a portion or all of the tax onto the purchaser of the device.

• Finally, there will be a “penalty” tax that will be phased into effect from 2014-2016 for those who choose not to have health insurance. The “penalty” will vary in size depending on your income, but current amounts start off at $695 a person up to $4,700 a person. Again, the size of the penalty you would pay depends on your income.

Final Thoughts

I hope this gives you a better idea of what is coming your way in regards to new taxes because of Obamacare. The premise of this post was to explain the tax side of the mandate. I am not trying to make this into a pro-Obamacare or anti-Obamacare post. I am simply writing about the new taxes many will experience. I wanted to do this because the media is solely focusing on the 3.8% tax that will hit certain income groups when there are many more aspects to new taxes that relate to Obamacare.

Readers, what are your thoughts on these new taxes? Do you see any that will impact you?

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If you are a fan of Dave Ramsey or other financial gurus, then you know they suggest starting out with $1,000 in an emergency fund while you pay down debt. Once the debt is gone, you are to increase the size of your emergency fund to six months of living expenses. Currently, the average length of unemployment is just under 10 months. Basic math tells me that six months of expenses in an emergency fund isn’t going to cut.

Photo source: StockMonkeys.com

Of course, you could (and should) cut back on your spending during times of unemployment to stretch that six months’ worth of money out so it lasts longer, but you need to remember two things. First, some expenses cannot be cut, like you mortgage, car payment, etc. and secondly, 10 months is only the average length of unemployment. There are people that are unemployed for much longer than that. Because of this, I recommend closer to 12 months of living expenses in an emergency fund.

Where to Stash the Cash?

When the math this done, you will realize that 12 months of expenses is a large amount of money. You will need to ask yourself, where will you keep this money? Hopefully, your answer is not “under the mattress” or “buried in the backyard”!

For most, they put their emergency fund into a savings account. When interest rates were higher, this was a great place to keep your money while keeping the principal safe from loss. This was also great when we were advised to keep six months of living expenses saved because not a large amount of money was sitting in a low interest bearing account. Now that I recommend 12 months of living expenses, we need to address where the money should reside.

Here is how I recommend divvying up you emergency fund. First, I would keep three months in a savings account. I know that interest rates are horrible right now, but this is a price to pay when you need to keep some money liquid. The rest of the money should go into either a short term bond fund or a TIPS fund. These two investment vehicles will allow your money to work for you as they both offer higher rates of returns as opposed to a savings account. You do need to understand that investing in these vehicles does not prevent you from losing principal. Let me repeat that: you can lose principal when investing in bond funds.

With that said, short term bond funds and TIP funds tend to be relatively stable over the longer term. There is very little day to day volatility in them which makes them a consideration when investing your emergency fund.

Some people may be asking why would you even invest some of your emergency fund? The reason goes back to the low interest rates of savings accounts. I’ve written before on inflation and how it eats away at your purchasing power. Investing part of your emergency fund in short term bonds allows you to stop inflation from eroding your purchasing power.

Wanna Be Bold?

For other readers that are more aggressive with their money, I offer this solution: put the entire emergency fund into short term bond funds. If you have a high credit line, you can easily use your credit card for any emergencies that arise. To pay the credit card bill (in full of course), just sell some of the shares in your bond fund. In most cases, it only takes about one day for mutual fund transactions to settle. Be certain to add in a few days for transferring the money to your bank account as well.

One more point on this is that you should not be worried about incurring capital gains taxes when you sell some shares. As I have said before, short term bond funds tend to be fairly stable, so any capital gain you experience will be minimal.

For The Not So Bold

For those out there who just do not feel comfortable risking some of their emergency fund in the market I offer the following solution. Take three months of your emergency fund and keep it in a savings account. With the rest of the money, you can invest in certificates of deposit. Place equal amounts of money in a one year, two year, three year and five year CD. This will allow you to take advantage of interest rates if they rise. Additionally, any interest you lose by potentially cashing out the certificate early is only three months’ worth. You should still come out ahead, or in the worst case, break even (meaning you get your principal back without any interest.)

Final Thoughts

I highly suggest you look into increasing the size of your emergency fund to 12 months’ worth of living expenses and also investing some of that money in short term bonds and or TIPS. It’s a great way to lessen the effects of inflation.

How much do you have saved in your emergency fund? Would you consider investing some of that money in short term bonds and/or TIPS?

More on Emergency Funds

• Emergency Fund or Retirement First?
• Emergency Funds 101
• Should You Use a Roth IRA as an Emergency Fund?

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In order to retire with a healthy amount of savings, you are going to have to save close to 15-20% of your income each year. For many of us, this is hard, if not impossible, to do. But there is a solution out there that can help you painlessly reach that level of savings. For the more aggressive people out there, I’ve already laid out a plan called burst savings. This plan has you save very large amounts of your income each year over a shorter period of time. If this is too aggressive for you, I offer the 1% solution.

Whatever you are currently saving, make it a goal of increasing that amount by 1% each year. This should not be difficult to do. If you get a raise at work, say 3%, treat it as though it was 2% and save that 1%. While this amount does not seem as though it adds up, with time on your side, saving 1% more does add up nicely.

Not Saving More

The gray line in the chart below shows how much money you will have in 25 years assuming you earn $30,000 per year and save 5%. It assumes you earn 6% per year and that inflation runs at 3% annually. Finally, it assumes you do not receive a raise at all, so you are consistently saving the same amount each year.

As you can see, in 25 years, you will have saved a little more than $79,000. This is a nice little sum of money, but it can easily be more. Let’s take the same facts from above, but assume that you increase your savings by 1% each year. Your savings will max out at 16% per year. (This means that once you are saving 16%, you will not save 17% the following year, but will continue to save 16% each year thereafter). Again, this does not take into account any increases in income.

As you can see, saving just 1% more each year for 25 years increases the size of your nest egg to $219,100. That is an increase of close to $140,000! This is highlighted by the blue line in the chart above.

Saving More and Earning More

Now the real fun begins. Let’s assume the same facts as above ($30,000 annual salary, saving 5% per year with a return of 6% annually for 25 years. Inflation is 3%.) But now you receive a 3% raise each year and save an additional 1% each year. Note that your savings rate maxes out at 16% again. After 25 years, you have saved over $332,000! That is a nice amount of money.

Final Thoughts

I hope you can see what impact saving just 1% more each year has on your savings. It doesn’t seem like a lot of money and in reality it isn’t. But when you factor time and compound interest into the equation, that small amount of money goes to work for you and in time, you will reap the benefits of it. I urge you to try out the 1% more savings calculator from the New York Times where you can play around with savings amounts, returns and time horizons to get a better feel for how much an extra 1% adds up to.

More on Savings

• Can You Have a 401k and an IRA at the Same Time?
• Retirement Planning Checklist: 43 Tasks to Get You Ready!
• Are You a Victim of Lifestyle Inflation?
• Reverse Strategy: Decreasing Contribution Percent
• Will Social Security Be Around in 20 Years?

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Inflation affects us every day. Rising food prices, higher gas prices, and higher clothing costs are just a few of the examples of inflation. It’s easy to see these examples because we deal with them in the day to day. The effect inflation has on our investments is another story. While you look at your annual 401(k) statement and see that you earned 6% last year, that number is not completely accurate. That number is a pre-inflation number. If inflation is 2%, your real rate of return is only 4%. Inflation “ate away” 2% of your earnings.

On the same note, look at your savings account which is currently earning 1%. With inflation running close to 3% currently, you are actually losing 2% per year on your savings. You still have the same amount of money in the account, but the purchasing power of that money has decreased 2%. What is an investor to do to earn a higher return?

Understanding TIPS

Treasury Inflation Protected Securities (TIPS) are long term bonds issued by the U.S. Government. In other words, they are loans to the U.S. Government. Investors who invest in TIPS are trying to preserve their purchasing power by limiting the impact of inflation.

Most bonds pay interest out every six months and that payment amount is fixed. If you purchase a bond with a 6% coupon, you are looking at $60 in interest payments in a given year. With TIPS, you still get interest payments twice per year, and the interest rate remains fixed. The only difference is that the payment you receive will fluctuate based on inflation.

How TIPS Work

The interest rate of a TIP bond will be slightly less than an equivalent bond. This is because the TIPS principal is adjusted twice per year according to the Consumer Price Index (CPI), which measures inflation.

For example, let’s say you buy $20,000 of TIPS that pay 2.5% interest. Over the next six months, the annual inflation rate rises at 3%. Your principal would increase from $20,000 to $20,300. This is an increase of 1.5%, which is half of the annual inflation rate. The reason it only goes up by half is because we only looked at the previous six months.

So your principal amount just increased, what about your interest payment. As stated before, the interest rate on TIPS is fixed, but the amount of interest you receive will vary. Originally on the $20,000, the interest received was $250 (20,000 x 2.5% /2). But now, your semi-annual interest payment is $253.75 (20,300 x 2.5% /2). While this sounds great, realize that if inflation decreases, your principal will be adjusted as well, this time, to the downside.

Determining if TIPS Are Better

Just because TIPS have an inflation feature, that does not make then a better investment. You need to do some basic math to determine if they are a good investment. Here is how you do that: Simply subtract the interest rate of a TIPS bond from the interest rate of an equivalent non-TIPS bond. If the current inflation rate is higher than the difference, then you should invest in TIPS. Here is an example. You are looking at two 10 year bonds, one being a TIPS bond. If the interest rate on the TIPS bond is 3% and on the non-TIPS bond it is 5%, then inflation needs to be higher than 2% (5% subtracted from 3%) to make the TIPS bond worth investing in.

Things To Consider Before Buying TIPS

TIPS seem like a great investment, but like any investment, they can lose money. If inflation is lower than what you anticipated, a non-TIPS bond most likely performed better than the TIPS bond.

Also, all of the above assumes you hold the TIPS bond to maturity. This means you do not sell the bond until the term is up. If you do sell before maturity, you will not receive face value for the bond.

One last thing to consider with TIPS is taxes. Tax is due every year on interest and any increases in principal. Realize that even though your principal amount changes every six months, you don’t receive that money until the TIPS bond matures. The IRS however, treats that increase as if you actually received the cash in the year of the increase. In other words, there is a decent amount of paperwork to deal with in regards to TIPS.

Final Thoughts

I am not recommending you rush out and buy TIPS. You need to determine if they are a good fit for your goals and objectives. As always, careful consideration should be given to any investment.

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Investing is supposed to be easy; you take an amount of money, invest it in the market, and let it grow in value over time.

If it is so easy, then why do so many people fail at it?

Here are 11 reasons why investors fail.

Hopefully you aren’t committing all of these mistakes.

If you commit any of them, take note of them and take action to correct them.

Reasons Why Investors Fail

1. No Financial Goals or Change Goals Too Often. If you are going on vacation, you have a plan, right? So why wouldn’t you have a plan for your money? After all, a typical vacation only lasts a week while you want your money to last your lifetime, and possibly more. Sadly, too many people have no plan and simply throw money into the market, thinking they will figure it out later. Later comes, and they still have no clue. Sit down and think about what you want financially. Once you have an idea, create a plan around it and stick to it!
2. Invest in the Wrong Securities. This doesn’t mean you invested in some now defunct internet start-up over Apple. What this means is you are invested in emerging market stocks when you have three years until retirement. You should have your money in more stable investments, such as bonds. Another example is having a portfolio asset allocation that is appropriate for your goals. If you are close to retirement, you should not be invested 100% in stocks. Understand what you are investing in. Stocks are for the long term, bonds are for shorter term periods.
3. Invest Emotionally, Not Rationally. You see the market up 300 points and think you have to get into this rally or conversely, you see the market drop by 300 points and sell everything. In both cases, you are acting on emotion. Do your best to take your emotions out of the picture. Expect short-term volatility, because it will be there. But always remember that you are in it for the long term.
4. Being Too Greedy. You see that Apple stock keeps rising so you go ahead and invest in it because you think it can’t lose. Or, you have lost much of your retirement savings in the past few years and to make up for it, you invest everything you have in technology stocks. Don’t be greedy. Stick to your plan. When you chase investments, you will get burnt. Trust me. I’ve done it and so have many others.
5. Relying on Experts. Tune into the business channel and you will see some expert pumping up a stock. You think that it sounds good and invest in it. Bad move. No one knows how the market is going to react. There might be a short-term pop in the stock the expert is promoting, simply because so many others are blindly following their advice. In time though, the stock will return to normal. Stay focused on your goals and on the plan you created for yourself.
6. Listening to Outdated Articles. With the internet, you can find a story on just about any topic you want. What you need to pay attention to is the timeliness of the article. There is no reason to get excited about what an article says if it is outdated. And with how quickly news travels, it can become outdated quickly.
7. Becoming Overwhelmed. There are thousands of mutual funds, stocks and bonds to invest in. You could easily spend your entire life researching each and every one of them. Too many fall victim to analysis paralysis. This happens when you have so much information, you end up not making a decision because you are overwhelmed with it all. Search out low cost index funds and stop there. Pick a few that will give you the allocation you need for your goals and more on. No need to research until you can’t take it anymore.
8. Investing to Save on Taxes. I hate paying tax as much as the next person. But there is no reason to invest in a security simply because it will save you on taxes. Realize that I am not saying you shouldn’t save in your 401k and IRA accounts. I think you should be contributing as much as the law allows you to. But don’t go investing in other products just for the tax savings. If they are part of your plan, then by all means, invest. If not, move on and invest to meet your goals.
9. Investing on Margin. Many investors were burnt in 2008 because they have too much money invested on margin. If you don’t know what margin is, it allows you to invest in securities without having the cash up front. If the security increases in value, you can sell it, pay your outstanding balance, and keep the rest. Problems arise when the security drops in value. In this case, you don’t need to sell it in order for the lender to get his money. Once the value of the security drops below a certain point, you need to add cash to your account to make up for the difference. My advice: don’t invest unless you have the cash. If you don’t have the cash, then save up until you do. There is no point into going into debt to invest money.
10. Not Understanding Compound Growth. The more time you have, the more your money can compound upon itself. Another way to explain compounding is that you earn interest on not only your principal, but also on the interest you have earned as well. As your investment account balance increases, the compounding of your money increases at a faster rate, earning you more money quicker. You won’t become a millionaire overnight, but your money will grow.
11. Fixed Income Does Not Mean Fixed Value. If you are investing in bonds, also known as fixed income, your principal invested can lose money. There is no guarantee that you won’t lose money. Bonds are less volatile than stocks and as a result are less likely to lose value, but that doesn’t meant they won’t.

What are your thoughts on this list? Should anything be added or removed?

More on Investing

• Are Morningstar Ratings Trustworthy?
• Best Online Discount Broker Comparison
• Are Municipal Bonds the Next Bubble?
• Mutual Fund Settlements

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Before investing in mutual funds, many investors inquire about the Morningstar rating, or star rating of a particular fund. If it has a high rating, they assume that it is a good fund to invest in. But is it? Just because someone else thinks a mutual fund is good to invest in doesn’t necessarily mean it is. You may be surprised to find that in the end, most of the Morningstar ratings don’t really matter.

Who is Morningstar?

Morningstar is a US based research firm that publishes data on both stocks and mutual funds. It is best known for its star rating system, where it provides investors with a sense of a fund’s performance. The start system rates funds from worst (one star) to best (five stars). Even if you have never visited the Morningstar website, you have most likely seen the star rating system. Open up virtually any personal finance magazine and the mutual fund companies that are advertising their funds will list their three and five year Morningstar rating.

According to the Morningstar website, Morningstar claims to bring risk and performance together through a complex math formula to determine each funds rating. The overall concept assumes that most investors are more concerned with losing money versus a good outcome that they were not expecting.

Taking into account the above definition of the rating system, the best performing funds, five star funds, have the highest risk-adjusted return and the worst performing funds, one star funds, have the lowest risk-adjusted return.

My Issue with Morningstar

The biggest issue that I have with the rating system is that it assigns star values to funds based on past performance. Any smart investor knows that past performance is not a predictor of the future. Granted, Morningstar does continually update their data on a monthly basis, but the fact still remains that a fund that has performed highly in the past will get a high star rating. Just because it performed great in the past doesn’t mean it will continue to do so in the future. I feel the system can mislead investors.

But is my concern valid? Maybe the Morningstar rating system is able to help investors pick winning mutual funds.

The Research

Professor Christopher Blake of Fordham University and Professor Matthew Morey of Pace University conducted a study from 1992 through 1997 to see if funds had a higher return based on the star rating system used by Morningstar. Their results were interesting.

When it came to the worst performing funds, those with one star, the researchers found that these funds were inclined to continue their below average performance in the future.

For funds with a rating of three, four and five stars, the researchers found very little evidence of these funds having superior performance. In other words, a three star fund was just as likely to have the same performance of a five star fund for the same period in the future. Another way to put this is today’s five star fund can easily become tomorrow’s three star fund and vice versa.

How To Effectively Use The Morningstar Rating System

I recommend against using Morningstar star ratings as your sole research tool when choosing funds. I recommend looking at a funds management fee, turnover, and any load it charges first. Then I would look at the Morningstar rating just to see if it has one star. If it does have one star, I would pass on investing in it. The study noted above validates this for me. If the fund has a Morningstar rating of three stars or more, then I know I can continue to do research to see if the fund is a good fit for my portfolio.

More on Investing

• What is an ETF?
• Why You Aren’t Earning What Your Mutual Fund Says You Are
• Best Online Discount Broker Comparison
• What is a Dividend Reinvestment Plan?

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I read an email from a long time reader, Gerald, here at My Dollar Plan on two posts that were recently published. They are Why You Aren’t Earning What Your Mutual Fund Says You Are, in which I wrote that the average investor earns a much lower return than the market due to the fact that the average investor jumps in and out of funds as well as the market chasing returns. The second post is Madison’s 2012 Asset Allocation Update where she went into detail about rebalancing and shifting her investments from an 88/12 portfolio to a 70/30 portfolio.

From the Mailbag

Gerald was wondering if the two posts contradicted each other. The simple answer is no, the posts don’t contradict, but I can see where there could be some confusion. Gerald also asked:

I was always wondering which one was better re-allocating funds every year or leave in the fund and let it ride?

Stay Invested for the Long Term

The point of my post was that the average investor, even though they are investing for the long term, tends to chase returns. They do this by buying a mutual fund and holding it for a few months, not getting the return they want and selling out and buying another fund. Additionally, they will pull out of the market and “sit on the sidelines” with cash when the market is dropping or is overly volatile and then enter back in when things calm down. The problem with this is that they are missing out on days when the market rises.

Because of all of that moving between funds and in and out of the market, the average investor earns much less than they could if they would simply buy into a few low cost index funds and ride the market.

Rebalance Your Portfolio

Madison’s post on the other hand is something that should be done, but many investors do not do: rebalance their portfolios. Rebalancing involves looking at your investment allocation plan and making sure that your current allocation matches that plan. If it does not, then you need to sell some funds where you are overweight and buy into funds where you are underweight. In other words, it forces you to buy low and sell high since the overweight funds most likely outperformed the market while the underweight funds underperformed the market.

Ideally, you want to rebalance your portfolio twice per year, and as long as the allocations deviate from your plan by 5% or more. Rebalancing when your allocation is out of line by less than 5% is not really worth it.

Additionally, as you grow older or have changes to your life, you may need to do more than a simple rebalancing of your portfolio. This is more closely to what Madison did. Her old plan had her at 88% stocks and 12% bonds. She realized this was too risky for her, given her circumstances and dialed it down to a 70% stocks/ 30% bond portfolio. Her ultimate goal is to get to a 60%/ 40% allocation.

Realize that she is not jumping in and out of the market or moving around from fund to fund on a regular basis. She is re-allocating her portfolio once and is sticking with what she has.

Hopefully this clears up any confusion there was between these two posts. If anyone has any more questions, or needs me to clarify anything further, please reach out to us here at My Dollar Plan.

More Investment Resources

• Best Online Discount Broker Comparison
• ETFs Versus Index Funds
• Stock Splits 101
• What is a Dividend Reinvestment Plan?

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