The Money Class (25 page)

5
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Rebalance your portfolio once a year
. One of the keys to successful long-term investing is to make sure you don’t overload on one hot investment, and by the same token, have too little in an underperforming investment. What’s hot today won’t be hot forever. What’s cold today won’t be cold forever. That’s why you want to rebalance: By constantly bringing your portfolio back in line with your long-term allocation strategy you are not making any outsize bet for or against any specific part of your portfolio.

Let’s say you started the year with 15% of your stock portfolio invested in international stocks and 85% in a U.S. stock fund. But at the end of the year, the international markets did so well, while the U.S. markets lagged, that your mix is now 22% international and 78% U.S. I realize this takes discipline, but you want to shift your money around—you can in fact exchange money from one fund to another within your 401(k) without any tax bill to get back to your target of 85–15. It’s also important to rebalance your overall stock and bond/cash mix so they stay in line with your long-term allocation strategy. Now, don’t go crazy with this; once a year is fine. Or if you’re feeling extra motivated, go ahead and rebalance every six months if your allocations are more than 5% off your targets.

That is my best advice on how to build a smart 401(k) portfolio that mixes the opportunity for inflation-beating gains (stocks) with more soothing lower-risk investments.

But I need you to stand in your truth. If, after reading that, you honestly can’t see yourself putting in the work to create that portfolio, well, then that is your truth and I will respect it. And I will tell you that your next best option—though inferior, in my opinion—is to choose the target retirement fund in your plan. I would rather you have your money invested in sync with your investment time frame rather than 100% of it sitting in cash, or company stock, or worst of all, you not participating at all. As I said, a target retirement fund may not be ideal, but if you are uncertain about your ability to choose your allocations and follow up on them once a year, this option might deliver peace of mind. If that is your truth, I can only support you when you choose to stand in it. And the reality is that because you are young, your target fund should have very little committed to bonds; the investment pros at the mutual fund company who are in charge of setting the allocation mix within your target fund know full well that you belong mostly in stocks given all the time you have. However, I will continue to hope that as you age and gain confidence you will take control of the allocation of your 401(k). Once you are in your 40s and 50s a target fund will most definitely invest more in bond funds than when you are in your 20s and 30s. So those later decades are the years when I would ask you to seriously consider stepping up and building your own portfolio so that you do not find yourself stuck in a target fund that is overloaded with bond funds.

THE BEST INVESTMENTS FOR YOUR IRA AND REGULAR TAXABLE ACCOUNTS: ETFS

For retirement assets outside your 401(k), you have the freedom to choose among the thousands of investments offered by the discount brokerage you use. That includes mutual funds, individual stocks, and individual bonds, as well as exchange-traded funds (ETFs). I think ETFs are an ideal way to invest the stock portion of your IRA. An ETF is very much like a mutual fund, except its fees tend to be lower. Another benefit is that unlike funds, an ETF’s price changes throughout the day to reflect changes in the value of its underlying holdings. A mutual fund, by comparison, has just one price a day, set at the close of business (4 P.M. Eastern). If you place an order to buy or sell a mutual fund at 11 A.M., your price will be based on the closing price at 4 P.M. If a disaster were to happen at noon that day there would be nothing you could do about it; you still would get what the price was at close of business. With an ETF, if you place your trading order at 11 A.M. it will go through immediately and reflect the current price of the ETF at that moment in time. Granted, your long-term retirement funds shouldn’t be actively traded on a daily and hourly basis, but I want you to understand the added flexibility you have with ETFs.

One of the big differences between an ETF and a mutual fund is that an ETF trades like a stock, and that means there is a commission to pay each time you buy and sell ETF shares. That’s a disadvantage compared to a no-load mutual fund, which does not charge a commission. But one of the most promising developments in 2010 was that some major brokerages including Fidelity, Schwab, TD Ameritrade, and Vanguard decided to eliminate or sharply reduce the commissions charged to buy and sell certain ETFs. For investors who want to invest on a monthly or quarterly basis rather in than one lump sum each year, the prospect of making commission-free trades is great news. Someone who invests monthly and in the past paid a $10 fee for each trade can now save $120 a year through commission-free ETF trades.

The website
morningstar.com
has a terrific amount of information and data about ETFs. I encourage you to educate yourself before you invest.

Some ETFs I recommend as good choices for building a diversified long-term retirement portfolio:

U.S. Stock ETFs

• Diversified index ETFs that give you broad exposure to hundreds of U.S. firms
  
• iShares S&P 500 (ticker symbol: IVV)
  
• iShares S&P SmallCap 600 Index (IJR)
  
• iShares S&P MidCap 400 Growth Index (IJK)
  
• Vanguard Total Stock Market (VTI)
  

Diversified International Stock ETFs

• Vanguard FTSE All World ex-U.S. ETF (VEU)
  
• iShares MSCI EAFE Index Fund ETF (EFA)
  

BOND INVESTMENTS

For the bond portion of your IRAs and any taxable accounts, I recommend you invest in individual Treasury bonds. Because these are backed by the U.S. government you do not have to worry about default risk. If you were to invest in corporate bonds you would need to build a diversified portfolio of 10 or more issues, and unless you have $100,000 or more to devote to bonds, the commission you would end up paying would be too expensive.

The discount brokerage where you keep your IRA should offer the ability to buy Treasury securities, or you can invest through TreasuryDirect.gov. Just remember to stick with shorter-term issues—maturities of five years or less.

RETIREMENT PLANNING MISTAKES YOU MUST AVOID

Now that you know the key steps to investing for retirement, I want to make sure you don’t make some costly mistakes along the way.

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Do not use retirement funds to temporarily fix a long-term problem
. There is no more costly mistake than using your retirement savings prematurely, to pay for something other than your retirement. Yet I know that many of you have felt compelled during the past few very rough years to pull money out of your 401(k) or IRA to make up for lost income from a layoff or reduced pay. Many more of you have come to me asking if it is okay to take money out of your retirement accounts so you can keep up with a mortgage payment that is no longer affordable.

My answer: No. It is not okay.

I say that with tremendous heartache for what I know so many of you are going through. But I am here to teach you what is best for your long-term security. And you will not be able to achieve your retirement goals if you spend your retirement savings today.

It is impossible for me to overstate how sensitive I am to the hardships many families are going through because of layoffs and other financial setbacks these days. And I certainly understand the desire to use your retirement funds to help you make ends meet during this difficult time. But I am going to ask you to stand up to a very important truth here: If you withdraw money from your retirement funds today, will you solve a problem for good, or will you just buy yourself a little time? Please answer that question based on what you know for sure today, not what you hope may happen in a month or two or three.

What I see so often is that wonderful, well-intentioned families think they are doing the right thing by taking money out of their retirement funds so they can keep up with a mortgage payment. This helps them for a few months, but then when that money runs out they are once again back at square one: They have a mortgage they can still not afford. Making matters worse, they now also no longer have their retirement savings.

It is important to understand that your retirement funds are protected in the event you ever have to claim bankruptcy. No matter how much you owe, no matter to whom you owe it, no court in this country will ever allow retirement savings held in a 401(k) or IRA to be used to repay your debts. Retirement funds are shielded. And you must understand that if you make an early withdrawal from your 401(k) you will owe income tax and a 10% penalty—if you are younger than 59½—on the amount you withdraw. So that reduces the actual amount of the withdrawal you will have left to use, after paying the tax and penalty. And please understand that if you fail to pay the tax and penalty, the IRS has the right to start taking the money you owe directly out of your paycheck.

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Steer clear of 401(k) loans
. So many of you are tempted to take a loan against money you have in your 401(k) plan to pay off other debts. For example, you tell me how smart you were to borrow $5,000 from your 401(k) through a loan that charges a low interest rate, to pay off your $5,000 credit card bill that charges you 20% interest. That’s not nearly as smart as you think.

Let me tell you about the payback rules: If you are laid off from a job, or if you decide to take another job, you must repay the loan that is still outstanding quickly, typically within a few months. If you can’t afford to do that, the entire amount of the unpaid loan will be added to your taxable income for the year, so not only will you owe tax on that amount, but if you are younger than 55 in that year you will also have a 10% early-withdrawal penalty to pay.

Furthermore, you will end up paying taxes twice on the amount you borrowed. There is another tax drawback to a loan. When you originally invest in a traditional 401(k) it is with pre-tax money. If you then “borrow” that money you will eventually repay it with money you have already paid taxes on. Now let’s jump ahead to retirement. The money you repaid with after-tax dollars is now part of the account you have never paid taxes on. And so when you go to withdraw that money in retirement, guess what? It will be treated again as ordinary income. So you’ve essentially volunteered to pay taxes twice.

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Don’t cash out your retirement funds when you leave your job
. Another common mistake I see is when people leave a job and they have just a few thousand dollars in their 401(k), so they decide to cash it out, rather than leave it to grow for retirement. This is one of the weaknesses of the 401(k) system: Once you leave an employer, regardless of your age, you are free to do what you want with your account. You can leave it invested at your old employer as long as you have over $5,000 in the 401(k); you can roll it over into an IRA (and convert it to a Roth IRA); and you also have the option to cash it out.

The cash-out option is a mistake that no one at any age can afford to make. Younger adults in their 20s and 30s are typically the most tempted to cash out when they leave a job. I understand what’s at play here: You are struggling to make ends meet and you look at your relatively modest 401(k) balance and see a chance to pay some bills, or maybe take a vacation, or upgrade your wardrobe for your next job. I am very sympathetic to how tempting it is to do the cash-out, but it is such a costly mistake. For starters, the money you cash out will be charged the 10% early-withdrawal penalty. Furthermore, if it was invested in a traditional 401(k) you will also owe income tax on the entire amount of the withdrawal. So right there you are walking away with a lot less money.

But it’s not just the tax and penalty that makes this a bad move. What I want you to focus on is how you are throwing away decades of compound growth. For anyone around the age of 30 who is considering pulling money out of their 401(k), I want you to always consider the 8x factor: Take the amount of your existing balance and multiply it by 8. That is what your account could grow to by the time you reach age 67, assuming it grows at a compounded 6% annualized rate.

So let’s say you have $5,000 in the 401(k) of a former employer. Leave that money invested for retirement and it could be worth more than $43,000 by age 67. I want you to reframe your thinking here. If you withdraw $5,000 today you will probably end up with less than $4,000 after paying the mandatory 10% early-withdrawal penalty and the income tax that is levied on all withdrawals. Or you could leave the $5,000 invested for retirement and possibly have a retirement fund worth more than $40,000. I hope that makes my point crystal clear: There is a potentially huge cost to cashing in a 401(k) when you are young.

WHAT TO DO WITH YOUR 401(K) WHEN YOU LEAVE A JOB

Instead of cashing out an old 401(k) when you leave a job, I want you to keep the money growing for retirement. If your 401(k) balance is at least $5,000 you typically will have the option of leaving your 401(k) in your former employer’s plan. If you know for sure that the 401(k) has great low-cost mutual funds, that can make sense. But I have to say I typically think it is far smarter to do what is known as an IRA rollover. This is a straightforward process where you move your money from the 401(k) into a new IRA account at your discount brokerage or fund company. The advantage of doing this is that, as I explained earlier, you will have the freedom to choose from a wider array of investments once your money is in an IRA, including direct investment in Treasury securities as well as ETFs.