Reader Mailbag: Pulling Up Friends

What’s inside? Here are the questions answered in today’s reader mailbag, boiled down to five word summaries. Click on the number to jump straight down to the question.
1. Buying a rental property
2. Building focus
3. Using a bad 401(k)
4. PMI or empty emergency fund?
5. NCAA tournament brackets in office
6. Employer 401(k) matching
7. Tiredness
8. Board games with kids
9. Math on retirement gains
10. Borrowing from a 401(k)

As I move forward with my novel, I’m trying to find ways to use it to help out friends and acquaintances. I have two old friends doing editing, another friend doing cover art (and perhaps other art), and another friend doing some promotional work for it. These people do these things professionally already.

The biggest reason I’m trying to do things this way is that if the book is a successful one, it’s not just my boat that will rise. The boats of some of my friends will rise, too.

Not only that, it will be a lot more fun to have a bunch of friends on a conference call than a bunch of people I barely know.

Q1: Buying a rental property
My husband and I are wondering if now is the time to buy a rental in our area (in Washington state). My husband is self employed in construction and has thankfully been able to stay busy but now it is slowing down. We don’t have any debt except for our house (5 acres with old farmhouse we have lovingly restored) We refinanced at 4% 30 year owing $229K and we have $16,000 in savings/budget. I am wondering if I should cash in my retirement ($13,000) for a down payment on a rental. We are hoping to have this rental and maybe another to fund our retirement. Our banker friend said we just need 25-30% down and its a go. Or we could maybe borrow from an uncle for the down payment. What is your opinion. We also have 3 kids (9,7,4.5) FYI

– Claire

I would absolutely not cash in your retirement to buy a rental home.

If you do cash in your retirement, you’ll have to pay taxes on that retirement money (assuming it’s in a 401(k)) as well as an additional 10% penalty for early withdrawal. Your $13,000 will become $8,000 pretty quickly. Not only that, you’ll have nothing put away for retirement, putting you way behind the curve for retirement savings. That $13,000, if left alone at 7% a year, will be $100K in thirty years. To turn $8K into $100K over the same timeframe, you’d have to have a roughly 9% annual return, which isn’t anything you will realistically find in any legal investment.

Providing a short-term bump for buying a rental home is not worth the rather large dip that will appear in your long-term retirement plan.

Q2: Building focus
How exactly did you build up the ability to focus for so long? You often write how you can make yourself slip into a state of intense focus for hours. How did you teach yourself to do that?

– Mike

For the most part, I didn’t teach myself to do that. I just created an environment where it easily happened.

The big keys for me are to find projects that interest me, then turn off all possible distractions when I settle in for work. If I am working on something engaging and I can’t be interrupted, I inevitably fall into a work “zone.”

I’ll admit that part of it might be how my mind works, but that’s really my recipe for success.

Q3: Using a bad 401(k)
I make $100k/yr and put approximately 10% of that into our company’s 401k. I also max out my Roth IRA on an annual basis. I would further use an IRA for tax sheltering if I could, but my income precludes me from any tax benefits (as I understand it). I also have an individual investment account that I put money into as well, but I don’t necessarily count that as part of my retirement savings; or more accurately I’m not counting on that money for retirement.

I’m pretty happy with my level of savings and my general financial situation. The only part of my current scenario that bothers me is my company 401k. First off, there is no matching policy. Secondly, the investment options in it are sparse and all have fairly high management fees (0.8% up to 1.5%). None of the options are particularly intriguing to boot. The problem is, I think I’d be remiss to bypass contributing to the 401k for the tax sheltering it provides. As far as I can tell, I can’t seem to find another way to shelter my income from taxes for retirement savings.

As I see it, I have to utilize the 401k for the taxable benefit it provides, but otherwise it’s a pretty weak program as it stands. The only thing I can do to improve the scenario is try to appeal to my company’s financial managers to attempt to offer a better suite of investment options, right? Obviously I’d love a matching program too, but that’s obviously not something an employee request could fulfill. Being that I’ve lived in the financial arena professionally as well, I’m not overly confident that changing the investment options will be all that easy either. Is there anything else that I should look into doing to try and find a tax-sheltered vehicle for my income?
– Tom

You’re basically right. The biggest advantage that a 401(k) has for you is that it defers your taxes until much later in life, which is fairly important for you in your income bracket (28%).

However, you’re not getting anything else out of this. All you’re getting is a tax deferrment to a time where your income level and tax rate are completely unknown, and to get there you have to put your money into some awful investments. You’re also restricted on when you can withdraw that money.

If I were you, I’d just put the money into an ordinary taxable investment account and invest it in some lower-cost investments. If you can save 0.8% a year in costs, over 35 years you’ll have your 28% in income taxes back. There are also the benefits of complete flexibility in how you use it and the strong possibility of being able to take advantage of long term capital gains tax rates.

You might also want to consider investing in things like municipal bonds, but be careful to stick to bonds with a high rating on them. Municipal bonds earn a solid return that’s often tax-free.

Q4: PMI or empty emergency fund?
I want to buy a home. I want to know should i pay the 20% down payment and keep very few thousand dollars in my account. or is it too risky? And shall I pay just 10% amount and keep a lot of money in by saving account, that means that extra 10% in my savings account for a bad day. I know that I have PMI to be paid if I do a down payment of 10%.

– Leland

Unless you specifically know what home you want to buy right now, I would be patient.

I would keep saving at a vigorous rate while I shopped at my own pace for the perfect home in my price range. Don’t settle for something that doesn’t suit you.

When you do find that place, you’ll likely have spent several months searching. You’ll have the perfect place, plus you’ll have several months of saving in your account which means you won’t completely destroy your emergency fund to make a full down payment.

Patience is the key, as always.

Q5: NCAA tournament brackets in office
At my office a large number of my coworkers fill out an NCAA basketball bracket each March. They have a betting pool based on the brackets. I could not care less about basketball and I don’t want to waste the money on the pool but I feel guilty about saying no to this. How would you handle it?

– Fred

Don’t look at it as money “wasted” on the pool. Look at it as money invested in building a stronger bond with coworkers.

In most careers, it is absolutely worth $10 once a year to spend a few weeks bonding closely with a group of coworkers, plus having the chance to occasionally touch on it again throughout the year. It does depend on the career path, but many careers depend a lot on the relationships you build, and this kind of thing can be a powerful relationship builder.

If you don’t know the first thing about college basketball, just wait until the brackets are out, pick the favorite in most of the matchups, and use Google to find a few upsets that pundits are predicting along the way. You probably won’t win, but you’ll do pretty well with that bracket.

Q6: Employer 401(k) matching
I know that I should contribute to my companies 401k to receive the maximum match that they will provide, so I am hoping that you could check my math below. I believe that I am going beyond this target and would like to move anything for future contributions beyond what I am getting a match for into a Roth. I know this will increase the amount I currently pay in taxes, but I believe this small increase will be wothwhile when I look to retire.

My employer matches 50% of my contributions up to 2.5% of my salary. If I earn $70,000/year my math says that in order to receive the full match, or $1,750, I only need to contribute 5% of my salary to the 401K.

If this is the case, I can move the remaining % of my contribution (currently I contribute a total of 14% to the 401K), a total of 9% into the Roth for all future elections? However, I believe the max contirbution for people under 49 (I am 31 years old, married with a 9 month old), is 5,000. So if I contribute 7%, which gets me to $4,900 per year, I can keep my 401K contribution at 7% as well?
– Ed

Your math is completely correct.

Furthermore, doing things this way hedges your bets against future taxation. We don’t know exactly what income tax rates will do in the future. If they go up, then the Roth was your better bet. If they hold steady or drop at all, then you’ll be happier about the 401(k) money.

If you put all your eggs in one basket, you might be thrilled, but you might deeply regret the bet. That’s not something you want to do with your retirement money. Diversification is always a good idea.

Q7: Tiredness
A while back, you mentioned that you have some amount of seasonal affective disorder and that it was particularly bad one winter before you discovered what it was and how to handle it. I’ve been utterly exhausted the last few months and I’ve been wondering if it is like what you had. How did you figure it out? What did you do to treat it?

– Kelly

The winter of 2008-09 was utterly miserable for me. I had a severe illness in November which kept me inside for most of the month and after it was over, we were locked into a terrible December and January for weather. My sense of day and night was completely out of whack and I was tired most of the time except for occasional periods where I felt completely fine, most of which popped up in the evenings around 9 PM.

My doctor suggested several things, but two things worked really well for me. One was a light box (this model, more specifically), which I use for an hour or so every morning starting in early November through February each year. I just sit it next to my computer monitor and work normally, and it switches off after an hour. It helps to adjust my brain to the idea that it’s morning, which means my body stays on some semblance of a normal day-night pattern in winter.

The other is simply getting outside as much as I humanly can. Thus, in mild winters (like this one), I barely notice it. In harsh winters (like 2008-09 and 2010-11), I notice it much more because it’s more difficult to get outside.

The more sunlight I get, the better, particularly in the morning. Nothing beats the real thing, but the light box is a very good substitute for grey winter mornings and harsh winter months.

Q8: Board games with kids
A few days ago, you mentioned playing a game called Flash Point Fire Rescue with your six year old son, and you also mentioned that it had rules for families and kids as well as advanced rules to make it a more compelling game. That sounds really interesting – a game I could play with my seven year old and five year old and also with my brother that I used to play Risk with. Are there any other games that balance “family” rules and more challenging rules like that?

– Tim

My best approach is to look for games that I can enjoy with my wife, then look for simple variation rules for them that I can play with my children.

A good example of this is the game Cartagena, which is by default a fairly thought-intensive game for adults. By simply eliminating the idea of using a hand and simply playing based on the card you draw off the top of the deck, the game became simple enough that my four year old daughter can play it well. There’s still a bit of thought involved, but it’s a much simpler game.

Look for games that appeal to you as an adult, then look for variants that would work with kids. That’s the path I’ve followed.

Q9: Math on retirement gains
I got my TSP statement yesterday and it showed that my total contributions over 10 years was $100,000. The Agency matches 5%. The total value of my TSP was $165,000. When I do the math, it says that over 10 years I made a 60% return…is this right? If so, the funds did very well even before/after the crash in 2008-2009!

– Virginia

Let’s just ignore the agency matching for a moment. Let’s say you’ve contributed $10,000 a year over the last ten years to your account. Let’s also say that your average annual return was 8%. Your balance after ten years would be very close to $150,000.

Given that I don’t perfectly understand how your agency’s contribution works, your conclusion seems reasonable. I don’t think there’s anything out of whack with those numbers.

2008 was a disastrous year, don’t get me wrong. The S&P 500 dropped 37.22% of its value. However, in 2009, it gained 27.11%. In 2010 it gained 14.87%. By the end of 2010, you’d gained back everything you lost in 2008 and then some. Before 2008, there was a run of five strong years in a row, including 2006 (+15.74%) and 2004 (+28.72%).

The stock market fluctuates like crazy. Your returns seem reasonable, but I would guess that right now they’re a bit above what I would consider the long term average. Warren Buffett predicts the long term annual return on a broad-based stock investment to be 7% going forward. You earned somewhere around 8% over the last ten years.

Q10: Borrowing from a 401(k)
I received a diversification election form from my employer as I am over 55 with 10 or more yrs under the Profit Plan. This gives me the opportunity to take a partial distribution of up to 25%. I only need to borrow $5000 but not if it will greatly impact my retirement. I know I will be paying a penalty tax as I am not 59 1/2 and the money will be taxable if not rolled over to an IRA which it won’t since I need this money for other uses. Please advise me of your suggestions.

– Alice

It depends on several things. How strong is your retirement savings right now? Are you on track to retire at the age you want with the money you have saved? How vital is your purpose for wanting the money now?

Rolling the money into an IRA and waiting five years is going to save you the IRS tax penalty. If you can wait five years for whatever it is you’re going to use the money for, then that’s what I’d do. I’d withdraw it as soon as I was eligible to do so from the IRS and move forward with whatever my plans were.

If you need the money, taking this money out is no different than tapping your other retirement savings. The IRS penalty really makes this a financial loser, but sometimes life intervenes.

Got any questions? Email them to me or leave them in the comments and I’ll attempt to answer them in a future mailbag (which, by way of full disclosure, may also get re-posted on other websites that pick up my blog). However, I do receive hundreds of questions per week, so I may not necessarily be able to answer yours.

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