One of the most amazing people I’ve ever met has chosen a path of volunteerism and social work for her life. She’s taken the gifts and talents God has given her and chosen to forsake several much more lucrative opportunities to participate in a social work program fraught with challenges that I wouldn’t face for all the money in the world. That she has the spiritual strength to spend her days helping those who cannot help themselves is amazing to me - but considering that it’s also going to be a strong financial challenge as well makes her choice all that more impressive.

Let’s see what we can do to offer her some useful financial advice - and also give similar advice to anyone else who may be choosing a path like this one. For starters, her income is going to be low with relatively minimal benefits for quite a while, and it’s likely that her exact position will change regularly over time. What can be done to ensure the most financial stability over the course of her life? Here are my suggestions - I’d love to hear more in the comments.

Build an emergency fund. In a field where jobs are often in flux due to changing fund situations, many people engaged in social work hop from job to job regularly and an emergency fund is often vital for bridging the gap. It’s simple - just put small amounts of money away in a savings account somewhere every single paycheck and then tap it when you really need it, like when you have to switch positions, your car dies, or something else disastrous.

Many volunteer workers know the benefits of doing this, but they go about it all wrong. They keep a nice hefty account in their hometown bank or in a local branch bank near where they do their volunteer work. A much better approach is to find a nice high-interest online savings account to conduct their business, provided of course that the volunteer has regular internet access. HSBC Direct is a reliable one and gives a 5.05% APY return with no minimum balance, which basically means if you have $5,000 you’d like to sock away before leaving on a twenty seven month stint in the Peace Corps, you’ll come back and find that it has earned $572 while you’ve been away.

Make a Roth IRA your friend. At some point as a social worker, you’re going to face old age and some form of retirement. You’re also a relatively low income worker who will need some flexibility in how much to contribute from time to time. A Roth IRA is a perfect retirement vehicle for anyone in this situation. In a nutshell, a Roth IRA allows anyone to contribute $4,000 a year ($5,000 a year starting in 2008) to a special individual retirement fund. What’s special about it? Once you’ve made the contribution (and you can remove your contribution at any time if you really need to), any investment growth on that contribution can be taken out tax free after you are 59 1/2 years old. No income taxes at all. Even better, once the money is in the Roth IRA, it can easily earn 10% a year, which means that $4,000 put in at age twenty five can build to $112,500 at age sixty. Contribute that amount every year and you’ll have $1.2 million in the account when you’re 60. Hold off retirement until you’re 70 and you’ll have $3.17 million in there.

How does one get started? Lots of investment houses offer Roth IRAs and make it quite easy to invest in them. I personally recommend Vanguard (http://www.vanguard.com) - their investment choices are all quite good and are based on very simple logic. I have almost every investment of my own through them.

Cultivate a strong network of friends and family. If you’re considering a life of social work and volunteer work, realize that you’re likely going to need support in various ways for a long time. Talk to friends and family and be sure that they will support you in this choice - not in a financial sense, but in a sense that they understand the choice you’re making and may be able to provide a couch or a guest bedroom on occasion.

On the other hand, if someone you know is considering making such a choice, offer such help to them. Make it clear that they’ll always have a bed and some meals in your home. They’re making a very difficult choice to do something that will make the world a better place - show how much you support their difficult choice.

Know how to live frugally. She was lucky in that her orientation gave substantial training in frugal living, but some social work situations do not. The first and best move is to know how to cook from yourself from staple foods - this is the simplest way around to save money. Also, check your ego at the door and be willing to shop at Goodwill and the Salvation Army and other places for clothes and other items. You can get pretty detailed with frugal living - search around The Simple Dollar or elsewhere online for all kinds of additional tips.

If you would like to help even more than giving advice in the comments, please consider giving a donation to an exceptionally worthy cause. The link goes to a page for the charity that she’s involved with which details the charity’s financial state, the work they do, and also gives a link that you can use to donate to the charity. If you have a few dollars to give, please do so - the charity is a 501(c)(3), which means that your contributions are tax deductible. If you’ve ever wanted to help out The Simple Dollar with a small donation, give to this charity instead - you’ll be helping out an amazing organization and a group of people that really need the help.

A reader writes in with an interesting scenario:

I’m 28 years old and I have two 401(k) accounts, both with about $30,000 in them. At the same time, I have about $25,000 in credit card debt because I made some very stupid moves a few years ago. I’m paying this debt down, but it’s at a snail’s pace - I have played some balance transfer games, but I still keep getting hit with finance charges. Even if I never charge another cent, I calculate that I won’t be able to pay off this tremendous debt until 2011. I have my financial life in order now and I’m spending much less than I bring in each month.

I am considering using one of the 401(k)s to pay off debt. Even after the tax penalties, my calculations show me that I’ll get about $21,000 out of one of them, leaving me with a little under $4,000 in credit card debt which I could eliminate by the end of the summer.

Should she do this? There are a few factors to consider here.

First of all, she’s 28 years old, meaning that she’ll be paying into a 401(k) for a few decades before she will retire. Given that she still has $30K in a 401(k) indicates that she’s putting a pretty heavy amount into them each month. While this move will obviously hinder retirement, it isn’t a complete disaster.

Second, that amount of credit card debt is a serious weight. She’s pretty clearly committed to paying it off the right way without damaging her credit any more than it already has been, which means that she’s going to have a long road ahead to get it all paid off. If she’s accruing finance charges on even some of it, it’s going to be very difficult to make significant forward progress on the debt without some sort of significant change in the situation.

Third, she’s looking at four years of intense debt repayment to dig out of her hole. That’s not easy, and to pull it off she’s going to have to have a very solid period of time in her life. If she loses her job or another significant event occurs, she could be in very significant trouble.

In the end, I find that this is one of those numbers versus emotions issues. You can draw up all sorts of models out of this scenario and many of them will say that she loses money in the long run by doing this. I tried plugging in some salary and 401(k) estimates and I found time and time again that looking at this situation from age sixty-five, even with conservative investment growth, it looks like a bad financial decision purely based on the numbers.

Yet I still think she should make this move. Without making it, she will be beholden to a significant debt over the next several years that is going to limit her choices and her opportunities in life. What if the perfect job came along for her, but she couldn’t take it because it meant an initial reduction in salary? She might pass up opportunities for love, for children, for many other things because of the burden of debt - it influences your mindset and decision making in countless ways. She’s 28 years old, she would still have $30K in retirement, and would be much closer to being debt free with this move.

Any additional advice here is more than welcome!

A reader wrote in with the following question:

I have read in many places that you should maximize your 401(k) contributions. To me it seems there are MANY definitions of maximizing this and I was wondering what you mean when you say you should be saving at least 10% of your income for retirement. Right now, I am contributing 5% of my income to my 401(k) program and my company is matching me one-to-one on this, so a full 10% of my pay is going into retirement savings, but using this method I don’t reach the maximum allowable contributions. So which is really maximizing my retirement savings? When you say 10% do you mean total including matching, or do you mean 10% from you yourself not including matching?

The advice to maximize one’s 401(k) contributions is solid advice, but it may not prove a realistic target depending on your income or family situation. Instead, many people recommend putting away 10% of your pretax income into some sort of retirement savings vehicle. Depending on how early you get started (the earlier the better - if you get started in your early twenties like I did, you’ll be just fine), 10% may in fact be all that you need the whole way along, but if you’re getting started later, you may need more than 10%.

Let me use an example of one of my friends, who makes about $40,000 a year but does not have a 401(k) at work. I advised her to start contributing to a Roth IRA immediately and maxing it out through automatic withdrawals from her paycheck, which she has started doing. She’s 22 years old, and if she invests $4,000 a year (which is 10% of her income right now) and earns only a 10% return on that money, when she reaches the magic age of withdrawal (59 1/2), she’ll have almost $1.5 million in there. While this won’t cover her retirement needs entirely, it will certainly help, and if she keeps increasing her contributions in parallel to her earnings all the way along, she’ll be in very good shape.

So, what about that 10%? Should you count your employer matching toward that number? My belief is that you should not count your employer’s match towards your 10% - you should view it as an immediate return on your investment as soon as you deposit it. In general, you’re always better to err on the side of having too much in retirement savings than not enough, because if you have “too much” when you start tapping it, it’s not a problem, but if you don’t have enough, then it can be a problem.

Let’s use another example. Joe is 25 and makes $30,000 a year. Over his life, Joe will average a 6% increase in salary each year until the day he retires at age 65 and starts tapping into his 401(k). His employer offers an equal match on the first 5% Joe puts into his 401(k), and the investment will earn an average of 10% a year. If Joe just puts in 5% and gets the match, he’ll wind up with $2.9 million at the end, a nice nest egg, but not a strong one in 40 years. By just contributing 5% more, Joe bumps that up to $4.4 million, which will put him in much better shape.

One more thing, though. If you are eligible for a Roth IRA (if your income is below $110K, you are), you should put money into one of those instead of putting unmatched money into a 401(k). Why? The income you earn from a 401(k) will be taxed when you withdraw it, but the income from a Roth IRA will be tax free. In other words, when you get money out of the 401(k), you’ll have to pay some percentage of it immediately in taxes, but not with the Roth IRA. It’s not as good a deal as the matching that you can get with a 401(k), but it’s better than putting money into a 401(k) unmatched.

So, here’s the plan: put money into your 401(k) as long as it’s matched, then put money into a Roth IRA, then put what’s left of your total 10% into your 401(k) plan.

An ultra-frugal reader writes in with an interesting question - why even bother with a 401(k)?

My husband and I have been living on about half our income for many years. If our expenses and savings rate stay about the same, we’ll have enough savings to live off the interest in about 7-10 years (depending on your assumptions about interest), including the ability to pay off our mortgage. Let’s say 10 years — I’ll be 44 then.

Conventional wisdom is that we should be pouring money into IRAs & 401(k)s because of the tax benefits. “It’s free money!” people tell us. And we do have a pretty good nest egg in those accounts. But lately I am wondering: if we can get to the point where we could be living off the interest of our non-tax-preferred savings a full 15 years before we’re allowed to even touch the money in our tax-preferred savings, don’t the retirement savings become kind of moot? Shouldn’t we just build up our early-retirement savings instead? Or am I missing something? Are the tax benefits to retirement accounts so great that we really should keep putting more and more into them? Do expenses go up significantly in later life so much that we’ll need to have a big infusion of cash?

First of all, I’m going to assume that your savings are in a well-diversified portfolio; if not, then everything I say below is moot. If it’s all sitting in a savings account and your window for touching it is more than ten years out, you need to seriously diversify into other investments, but that’s another article.

Now, if your portfolio is diverse and you believe that you’ll be able to live off of the income from this portfolio in ten years, you need to remember two things. One, inflation is real, and your portfolio still needs to grow even after your withdrawals each year by about 4% or so (at least). Without that growth, everything will get progressively more expensive while your income level stays the same. Two, you need to remember the benefits of work as well; health insurance, in particular, will be an expense after making this move.

If you’ve got all of that covered and you can still walk at age 44, that’s fantastic, and a 401(k) probably is a waste for you because you will pay much lower taxes by putting that money directly into your investment accounts (assuming that you will follow through on your plans to retire at 44 with a relatively lower income from your investments than you have right now from your employments). For most people, a 401(k) is a very good thing - for your situation, though, I don’t believe that it benefits you.

However, a Roth IRA may still be worthwhile for you - at least, it is worth considering. Much like your investment portfolio, it is built with after-tax money. However, unlike your investment portfolio, you are not hit with capital gains tax when you go to withdraw it. Let’s say you’re in the 15% tax bracket and you put $4,000 a year into a Roth IRA for ten years and it grows at 10% a year, and you also put $4,000 a year into a mutual fund. At the end of that period, they’ll both have a value of $63,749.70. But, you’ll be due to pay capital gains tax on $23,749.70 of the mutual fund, but you won’t owe a dime on the money inside the Roth IRA. That’s going to be a difference of at least a few thousand dollars, and likely much more than that for your situation.

The only drawback of the Roth IRA is that you can’t tap it until you’re 59 1/2 without some serious penalties, but if you have your financial house in very good order, the tax advantage of a Roth IRA makes it worthwhile, even giving this reader’s exceptional situation.

In my recent review of the April 2007 issue of Money Magazine, several people were quite interested in my comments on the early retirement article that appeared in the magazine. In brief, here’s the part that was interesting:

Assuming you want to retire at age 60 and plan to have no pension and no job in retirement, you need to have…
1.6 times your salary in savings at age 35
3.5 times your salary in savings at age 40
5.8 times your salary in savings at age 45
8.5 times your salary in savings at age 50
11.9 times your salary in savings at age 55
16.0 times your salary in savings at age 60

These figures assume a 35 year retirement starting at age 60 with 80% of your current salary each year, and with Social Security kicking in at age 62. It also assumes a 4% annual real rate of return (that means it includes inflation) on your investment and that you’ll withdraw 4% of the total balance the first year and then the same dollar amount adjusted for inflation each subsequent year.

So let’s look at what this looks like for a real person. Joe has a salary of $50,000 and wants to make sure his portfolio is doing good.

At age 35, he should have $80,000 socked away. This is a tough one to get to - Joe’s better off starting as early as he can to get to this number. If he puts $5,000 away each year starting at age 25 in an account that earns 9% annually, he can get to that number, though. $5,000, broken down, means a little less than $100 a week, so putting away $100 a week is a good place to start. If you start later, you need to put more than that away each week: if you start at age 28, for instance, you need to be socking away $160 a week.

At age 40, he should have $175,000 socked away. If Joe made the threshold at age 35, then he can make it to this threshold by socking away about $120 a week into that same 9% account.

At age 45, he should have $290,000 socked away. If Joe made the threshold at age 40, then he can again make it to this threshold by socking away that same $120 a week into that same 9% account.

At age 50, he should have $425,000 socked away. That same $120 will actually be getting Joe a little bit ahead of pace: if he met the threshold at age 45 and keeps socking away that $120 into that same 9% account, he’ll be just shy of half a million at age 50.

At age 55, he should have $595,000 socked away. With that same $120 a week plan, Joe will have almost $800K socked away at age 55. That’s pretty close to what he’ll actually need to retire at age 60.

At age 60, he should have $800,000 socked away. With that same $120, Joe will have $1.2 million in the bank.

What about raises? The numbers in Money Magazine take both inflation and raises into account. Each time your salary goes up, your actual numbers that you need to hit will go up as well. That’s why proportional saving is the key: it ensures that your retirement will grow to match the lifestyle your salary affords you.

So… how much should I be saving for retirement each week if I want out at age 60? It depends on your age. If you can get 1.6 times your annual salary into retirement savings at age 35, then you need to be putting about a quarter of a percent of your annual salary into your retirement plan each week to be able to retire at age 60 and just enjoy life. So, if you make $50,000 a year, that means an investment of $125 a week into your 401(k) and/or Roth IRA should be sufficient to lead to an enjoyable early retirement.

Five Minute Finances is a series of tips on how you can save significant money or reorganize your financial life in just five minutes. These tips appear Monday, Wednesday, and Friday on The Simple Dollar.

If you haven’t started up a 401(k) plan (if you’re an employee) yet, what are you waiting for?

Let’s say you make $40K a year and you’re twenty five years old, meaning you’ll retire sometime around the age of sixty five. Even if you just contribute 1% of your salary - less than $10 a week (and it’s employee matched) into your 401(k), it returns an average of 8% a year, and you only get a 4% raise a year, do you know how much you’ll have at age sixty five? $369,388. If you make that donation just 2.5% - still less than $20 a week before taxes, meaning only about $15 a week out of your take-home - and get the employee match, you’ll have $923,471 in your retirement account at age 65, just shy of a million bucks. In short, a 401(k) plan can add up to huge amounts of money - and it doesn’t cost very much, either.

Even more impressive is the fact that most companies offer a match for every dollar you put in. Quite often, this can go as high as 5% of your paycheck that they’ll simply give you if you put it into your retirement account. All you have to do is invest.

I don’t know anything about investments! Don’t worry about it. Put it all in a target retirement fund (something almost all 401(k) plans offer) and let them do all of the investment managing for you.

But what about the folks who got ripped off by Enron? Since that debacle, retirement plans have had new rules introduced that protect you from such a catastrophe - they’re not allowed to invest all (or even most) of your retirement plan into the company’s stock. In other words, even if your organization collapses, your money won’t just disappear.

Make the phone call right now to your organization’s human resource office and ask to start up a 401(k) plan, even if you know nothing about investing. Tell the person you just want all of it in a target retirement fund, which means someone else manages the whole thing for you based on when you’re expecting to retire. I’d recommend putting in as much as your company matches for starters, but as you can see, even a couple of percentage points isn’t bad.

Inflation is one of those topics that crops up time and time again on the news, and it’s one of those topics that makes my wife’s eyes immediately glaze over. It’s not long before the channel has been turned or the newspaper page has been flipped. Yet inflation (and avoiding it) is one of those things that really makes the world go round - and repeatedly affects your wallet.

What is inflation? Inflation refers to a situation where something costs more today than it used to. For example, when my father was young, he used to buy a dozen chicken eggs for a dime, but today it easily costs a dollar. If you do the math on this, you’ll discover that it comes out to about 5% annual inflation.

How does inflation affect me? For the average person’s wallet, inflation is generally a bad thing. It means that with every passing year, your dollar (or euro or pound or currency of choice) is worth less than it used to be. When inflation is high, your dollar is getting cheaper faster; when it’s low, your dollar is still getting cheaper, but not as fast. Here are some ways that inflation affects your everyday life:

Higher prices at the grocery store When inflation is high, the prices at the store are going to go up faster.

Low interest savings accounts actually lose money If your savings account has a lower rate than the rate of inflation, your money is actually becoming less valuable over time. This is a good reason to find a high-interest savings account, so that your savings can beat inflation.

When inflation is high, interest rates on home loans, credit cards, and other big loans will go up. This will overall encourage people to spend less money, and thus sellers won’t be able to keep raising prices, so inflation will slow down. The government actually controls how this works through the federal reserve, which I talked about earlier.

How do I understand a news report about inflation? For most people, the important thing to listen for is the Consumer Price Index, or CPI. This is a number calculated by statisticians and released by the United States government on a monthly basis (many other first world nations also release a CPI monthly). The whole story usually revolves around this number and how quickly it is going up. As a consumer, the lower this number is, the better.

Should I really care? In the short term, inflation isn’t that big of a deal - it generally stays around 3 or 4% annually, so it doesn’t affect you too much on a daily basis.

Where it is important is when you’re looking at retirement. Let’s say you make $40,000 a year and you’re thirty years from retirement. Using a quick rule of thumb, you figure you’ll need $1 million in your retirement account to retire. Not so fast. You’re actually figuring that million dollars without thinking about inflation. The truth is that with 4% annual inflation, you’re going to need $3.24 million in thirty years to equal what $1 million is worth today. Scary? For me, it’s just a reminder that I need to start investing for retirement NOW, not later. Every time you hear an inflation report, remember that it’s a call for you to invest for your retirement.

My wife and I are currently contemplating an interesting question: should we borrow against our retirement plans in order to make a 20% down payment and avoid PMI or an adjustable rate mortgage? We’ve arrived at an answer to this question, but it’s not an answer that works for everyone, so let’s work through the process we used before we reveal our decision.

First, we calculated what we’re going to spend on a home. We are currently looking at a $175,000 home. This means that a 20% down payment would be $35,000. We have easy access to a significant portion of this, but we would prefer to leave it as an emergency fund, so we’re going to use $5,000 of this for part of the down payment. This means we have to come up with $30,000 to avoid paying PMI.

Next, we estimated what our PMI would be per month. We used the GoodMortgage.com PMI calculator, calculating the sale price of the home at $175,000, our loan amount at $170,000, and our interest rate at 6.25% at 30 years, and it estimated we would have a monthly PMI payment of $147.33. It also estimated a monthly principal and interest payment of $1,046.72.

Then, we estimated what our payments would be per month with the full down payment. If we had the full down payment, we would be borrowing $140,000 on the home, which gives us a monthly principal and interest payment of $862.00 at the same rate over the same period.

How much more does it cost to not have the full down payment? Each month with PMI, we would spend $1194.05, while without PMI, we would spend $862.00. The difference in monthly payments is $332.05. However, what we’re really concerned about is how much each month goes towards equity, so we used the Bankrate.com mortgage calculator to see how much goes towards equity in each situation. We selected a few months during the life of the mortgage for comparison. With the PMI, we would be putting $161.30 towards equity the first month, and unless we overpaid (which makes things much more complicated), we would lose the PMI payments in the tenth month of the tenth year of the mortgage, at which point we would be putting $316.91 towards equity. On the other hand, without PMI, we would be putting $132.84 into equity, and in that magic tenth month of the tenth year, we would be putting $260.98 a month into equity.

What that means is that in the first month with PMI, we would be paying $1,032.75 to the bank with no real return, while at the magic month when PMI goes away, we would be paying $729.81 in interest. On the other hand, without PMI, we would be paying $729.16 in interest the first month, and $601.02 during that magic month.

In short, over the term of the PMI, we would be paying about $300 more a month in interest/PMI, and even after the PMI ends, we would still be paying about $125 a month in extra interest without borrowing, a point we wouldn’t arrive at for almost eleven years.

PMI is really going to hammer you guys. What about borrowing against retirement? My retirement plan allows me to borrow $30,000 for a home purchase at 4.125%, but it has to be repaid in ten years. Thankfully, this is a cash loan - my actual retirement investments are merely collateral for this loan. If I take out that loan, I will have to make a monthly payment of $305.52 per month for ten years, then it’s repaid. At that rate, the first ten years of the loan are roughly equal with or without PMI (regardless of overpayments). However, once those ten years are over, we will be saving about $125 a month by borrowing against the retirement account.

Thus, given our situation, we feel we are better off borrowing against retirement than accepting PMI. The key difference for us is that the borrowing does not affect our retirement investment directly and once the first leg of the loan is over (which is equally bad in terms of monthly payments, but we are paying more principal each month with the non-PMI route), we are in substantially better shape.

It is important to note that if our retirement borrowing actually took money from our retirement investments, it would be a completely different story, as investment losses in the retirement account would eat away pretty much all of the gains from the lower interest rate - and probably then some more, too. If you can’t get a loan with your retirement as collateral, you shouldn’t actually borrow directly from your balance.