Ask Dr. Don
Today Dr. Don discusses 401(k)s
for beginning investors and IRA early withdrawal penalties.
401(k)s for beginning investors
Dear Dr. Don,
My husband just started a new job. He's 23 years old, and this is
his first opportunity to invest in a 401(k) plan. We're certain
we want to participate in the plan, but uncertain about how to choose
the investments. The information packets don't seem to help. Can
you explain details that we should know about a 401(k)? My husband
has the option to use a percentage of his 401(k) money to invest
in stocks. Can you give us some tips about how to invest the plan
in stocks and tell us what we should be aware of? Thanks!
It's great that you're starting out investing in your retirement
in your 20s. The earlier you put retirement money to work, the easier
it is to meet your financial goal of a secure retirement. Don't
forget to invest some money outside of the plan for the shorter-term
financial goals, too, like the down payment for a house or car.
Make sure you understand the provision of the
plan. Many companies fully or partially match their employees' contributions.
At a minimum your husband should contribute enough to the plan to
maximize the employer's matching contributions.
Letting 401(k) plan participants invest in individual
stocks is a fairly recent phenomena and still not widespread among
plan providers. I actually can't recommend that he invest in individual
stocks when he's just starting out investing in a 401(k) plan, unless
his employer is giving him a deal on the company's stock. It would
be more appropriate to start out investing in a rather broadly diversified
portfolio of stocks.
A diversified portfolio reduces volatility (price
swings) in the portfolio's value. There are three principal ways
of building a diversified portfolio with small investments. One
way is to invest in mutual funds. Mutual fund investors receive
the return earned on the holdings in the fund's portfolio less any
fees or expenses. A no-load mutual fund doesn't charge a sales commission
but still charges management and marketing expenses. You can review
a fund's expenses either in its prospectus or online using Morningstar.com.
Mutual funds indexed to various stock and bond benchmarks can be
reviewed on Indexfunds.com.
The second method is to buy shares in exchange
traded stock indexes. For example QQQ is the trading (ticker) symbol
for the NASDAQ 100 Trust Shares. Buy a share of QQQ and you are
buying fractional ownership of the 100 stocks that comprise the
NASDAQ 100. The S&P 500 has its own trust shares trading as
SPY, but commonly called spyders. Thirdly, if the plan allows it,
he could create his own portfolio of stocks using a site like FOLIOfn.com,
These portfolio sites have different approaches to portfolio construction.
He can buy a portfolio off the rack, or create a customized portfolio.
Just starting out, it's important to manage
your fees, commissions and expenses as part of choosing your investments.
A $10 brokerage commission on a $100 biweekly investment means a
10 percent transaction cost to get in to the investment. A mutual
fund that has an annual expense ratio of 1.5 percent will act as
a drag on your returns. Put together a table that compares the expenses
associated with the three approaches. For example, FOLIOfn charges
either $29.95 a month or $295 a year to hold up to three portfolios.
That's almost 3 percent on a $10,000 portfolio, actually more than
that on a percentage basis because the $10,000 was invested over
the first year so the average balance for the year would be less.
You'll also want to keep your asset allocation
in mind. That is, you'll want different types of investments to
decrease risk and volatility. Check out this Bankrate.com
article on asset allocation.
Another great place to learn more about 401(k)
investing is at SmartMoneyUniversity.
IRA penalty kick
Dear Dr. Don,
What are the consequences of early withdrawal from a traditional
IRA? Is it a good idea to pay debt/credit cards with a withdrawal?
I am 37, have $77,000 in a traditional IRA, would like to pay off
$10,000 to $15,000 in credit card debt.
When you withdraw money from your IRA, you'll have to pay income
taxes and a 10 percent penalty on the withdrawal. The money would
have been taxed when you took a distribution in retirement, so the
difference is the 10 percent penalty. All of a sudden it doesn't
sound so bad, does it? If you're paying 17 percent on the credit
cards, then taking the 10 percent penalty doesn't look too bad.
Well, let's think this through. Let's say you
have a marginal federal income tax rate of 28 percent, and a state
tax rate of 7 percent. So after considering income taxes and the
10 percent penalty, you'll need to withdraw about $27,273 from your
IRA to have $15,000 to pay off the credit card debt. If you earned
8 percent on that money over the next 28 years, at age 65 the $27,273
would be worth $235,000 (before taxes).
One way to avoid the penalty is to annuitize
your IRA. You would start taking annual distributions from your
IRA. The problem is that you would have to continue those annual
distributions for five years or until age 59½ -- whichever
is longer. It's a long-term solution to what should be a short-term
problem. I don't recommend this alternative but if you want to pursue
has a worksheet that will help you determine the annual distribution
on your IRA.
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--Posted: Oct. 23, 2000
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