Financial Planning

12 New Rules for Your Money

In this era of high unemployment, flat home prices and do-it-yourself retirement savings, some traditional rules of saving and investing are due for an overhaul.

Renting may beat buying. Buying wins hands down when home prices are rising. But when they're flat or falling, it makes sense only if you get a great deal, your monthly payment won't exceed rent on a comparable home by much, and you'll own the home long enough to recoup your costs for both buying and later selling your home. Check out our Are You Better Off Renting? calculator.

Consider a Roth. Although the traditional rule of tax planning is never to pay a tax bill today that you can put off until tomorrow, Roth IRAs and Roth 401(k) plans stand that rule on its head. With a traditional IRA or work-based retirement plan, you get an upfront tax deduction, but every dime you withdraw in retirement is taxed at your ordinary income-tax rate. With a Roth, you forgo the upfront tax break, but all withdrawals -- including decades of earnings -- can be withdrawn tax-free. If income-tax rates rise, a pot of tax-free retirement income could be a financial lifesaver. To contribute to a Roth IRA, your income in 2010 can't top $120,000 if you're single or $177,000 if you're married. Anyone, regardless of income, can now convert a traditional IRA to a Roth IRA, but you'll owe taxes on the entire amount. There are no income-eligibility limits to contribute to a Roth 401(k), but not all employers offer them. (See Why You Need a Roth IRA.)

Focus on dividends. Invest in stocks that pay dividends. Your options should continue to expand -- more companies are paying dividends, and many of the elite dividend-paying members of Standard & Poor's 500-stock index are upping their payouts to shareholders. True, dividends do not guarantee that a stock will be a winner. Some failed big banks used to pay high dividends, while highfliers Apple and Google don't pay a penny. But during periods of market volatility, when stock prices tend to bounce around in reaction to political and economic gyrations rather than accurately reflect corporate fundamentals, dividends can provide a predictable income stream. That's not going to make you rich, but it is a comfort when other traditional sources of income have slowed to a trickle (see 10 Great Funds That Deliver High Income With Dividends and Interest).

Personalize your emergency fund. The standard advice is to keep enough in savings to cover three to six months' worth of expenses. But a lot depends on the stability of your job and the predictability of your income. The greater the risk your income could drop, the larger your emergency fund should be. If you think your job is in jeopardy, aim to save at least a year's worth of expenses; ditto for individuals with erratic incomes, such as those who work on commission. Retirees should keep two to three years' worth of expenses in money-market funds, short-term CDs or other liquid investments. The goal is to keep enough cash on hand so that you don't have to sell stocks or rack up expensive credit-card debt if you have an emergency, but not so much that you miss out on the higher returns you can earn on longer-term investments. (See How Much Cash Do You Really Need?)

Think McCottage, not McMansion. If you decide you're ready for homeownership, stick with the traditional (and temporarily forgotten) rule of thumb that you can afford a mortgage equal to up to three times your annual gross income. Most lenders will limit your total monthly housing payment -- including principal, interest, insurance and taxes -- to 28% of your gross income (and your total debt load to 36%). With a down payment of 20% and a 30-year fixed rate of 5%, a couple with a $100,000 income can afford a mortgage of up to $300,000. (Federal Housing Administration mortgages require just 3.5% down, but the smaller your down payment, the bigger your mortgage and the less house you'll be able to afford.) Calculate your eligibility based on a 30-year fixed-rate mortgage. Then decide whether you would prefer a lower-cost adjustable-rate mortgage with an initial fixed rate geared to how long you plan to stay in the house.

Age 66 is the magic number. Although you can begin collecting Social Security benefits as early as age 62, your benefits will be reduced by 25% or more. Better to hold out for full benefits at your normal retirement age -- 66 if you were born between 1943 and 1954; older if you were born later. Once you reach your normal retirement age, you can continue to work while collecting benefits without fear of bumping up against the dreaded earnings cap, which trims $1 in benefits for every $2 you earn over the prescribed limit. In 2010, the earnings cap is $14,160. If you're willing to wait until age 70, you can collect the maximum retirement benefit for you and your surviving spouse. (See Boost Your Social Security Benefits.)

Cut your credit-card debt, but not your cards. Minimizing credit-card debt is a great goal, but closing old accounts could hurt your credit score. About one-third of your FICO score (the credit score most lenders use) is based on your credit-utilization ratio, which is the total of your credit-card balances divided by the total of your credit-card limits. What counts is how much you've charged, regardless of whether you pay your balance in full each month. A good target is to use 20% -- or even less -- of your available credit. If your card company has raised your interest rate or imposed an annual fee, you might want to close the account and take a temporary hit to your score. But don't do it within three to six months of applying for a loan. (See Fast Ways to Improve Your Credit Score.)

Lock in your retirement income. Without a pension, you're on your own to figure out how to make your savings last a lifetime. You can use a portion to buy an immediate annuity, which will guarantee monthly payments for the rest of your life. The older you are and the higher interest rates are, the bigger your annuity payout. But you might want to wait for rates to rise before locking up your money. (See Buy a Pension With an Immediate Annuity.)

Think single-digit returns. Reality check: You should be happy to get 6% a year if you've dialed down risk in preparation for retirement and downright joyous if your overall investments earn 8% annually over the next ten years. Think of the past no-growth decade as a bridge from the unsustainable high returns of the 1980s and 1990s to an era of more-moderate performance. It's time to set a lower total-return target, not only for stocks but for your other investments, too. The performance of large-company U.S. stocks has been flat since 2000, and small-company stocks are losing steam. With interest rates near record lows and economic growth and inflation subdued, bonds and commodities aren't likely to post double-digit returns, either. Emerging economies, such as China and India, will continue to grow, but as their economies mature, investment returns will moderate. (See The 8% Solution.)

Retire your mortgage when you do. A house is a long-term investment with attractive tax deductions for mortgage interest and property taxes. It's great during your highest-earning years, but a monthly mortgage payment represents a major portion of most household budgets. One of the best ways to reduce your costs in retirement is to pay off your mortgage by the time you retire. It's best to whittle away at your loan during your final years on the job, making extra payments if necessary. Unless you have a big chunk of savings to pay off your home loan, you could run low on cash and be forced to borrow for future expenses, such as buying a car or replacing a roof.

Spread your assets around. There's no good formula for the right percentage of stocks in your portfolio -- especially the old 100-minus-your-age rule. A fresh idea is to start with 50% and slide the percentage up or down based on your personal situation. If you're 30, you can tilt your long-term money heavily toward stocks but keep your short-term savings in easy-to-access accounts. If you're 60 and have a secure pension and little debt, you can angle for some growth with your long-term investments, perhaps putting 65% in foreign and domestic stocks. Cast a broad net. There are many high-powered alternatives to stocks -- such as emerging-markets bond funds, currency funds, commodities and exchange-traded funds -- that weren't common when the traditional advice was to invest heavily in blue chips.

Save early for retirement. Paying off debt should be a top priority, but don't let your single-mindedness get in the way of your long-term goals. If your employer offers a matching 401(k) contribution, save at least enough to capture the match. Otherwise, you're walking away from free money. Ideally, you should aim to save 15% of your gross income for retirement (include your employer match in that calculation). If your boss doesn't kick in some cash, that's an even better reason to save on your own, either through your employer-based plan or in an IRA. You can start small -- say, 3% of your gross pay -- and allocate a portion of future raises to retirement savings. As you eliminate your debt, you can save even more. The magic of compounding will do the rest.

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