Six Money Dilemmas
by Janice Revell
Monday, December 17, 2007provided byMoneyonCNNMoney.com
As you invest your money, shop for a home or tackle any one of the many financial decisions you have to make over your lifetime, do you sometimes wish you'd paid more attention in math class? Do you find yourself having to "run the numbers" and wondering how?
To help, we've taken six common financial quandaries and done the math for you. As you'll see, the solution isn't always black and white, and the "right" answer may depend on things that you can never know for sure, like your tax bracket in 2020 or how much your investments will grow.
Plus, at times emotional considerations may tip the balance. Even if the math favors buying stocks over prepaying your mortgage, say, you may simply sleep better being out of debt. So this guide will walk you through the caveats as well as the calculations. Use it to navigate some of your financial life's trickiest questions and come up with your best call.
Pay off a credit card OR fund your 401(k)
You should do both. If you can't, pay off the plastic first.
In an ideal world, you'd wipe out your costly debts and save for retirement. But in the real world, you may not have enough cash to do both at the same time. Of course, you must pay at least the minimum on your credit card every month. So the question is, Do you put the rest of your available cash in your 401(k) or devote it all to your credit card?
Strictly by the numbers: By paying off credit-card debt, you get a guaranteed rate of return equal to your interest rate (the average is 14 percent today). But if your employer matches your 401(k) contributions, that's a 50 percent return (assuming the typical 50¢-to-the-dollar match on the first 6 percent of your salary).
Hard to beat. Or is it? The 50 percent match is a one-time gift; the 14 percent interest will compound every year. At some point the cost of that interest will overtake 50 percent. So if you have a big credit-card balance, attack that first.
Here's how that could play out if you're deciding what to do with $250 a month. With a $5,000 credit-card balance at a 14 percent rate, your minimum payment is $125 a month.
Suppose you put the rest in your 401(k). Because you don't pay taxes on that contribution, you can actually invest $174 a month (assuming a 28 percent tax rate). Keep paying $125 a month on your credit-card balance, and you'll need 55 months to wipe it out. During that time if you earn 8 percent annual returns and get the standard 50 percent match you'll amass $17,271 in your 401(k).
If you ignore the 401(k) for a while and instead plow your entire $250 toward the credit card, you'll pay it off in just 23 months. Then you could devote all your spare cash to your 401(k). By the end of the original 55 months, you'd have $18,515 in your plan. The one-at-a-time approach beats splitting your money because 55 months of paying 14 percent interest outweighs the 50 percent match.
But wait. Suppose your credit-card debt isn't that big, and you can pay it off in just a couple of years even if you split your cash. Great. Go ahead and fund both goals. You'll get the benefit of the 50 percent match.
You do the math: To see how long it would take you to pay off your credit cards, use the calculator at Bankrate.com.
Beyond the math: Good savings habits are important too. If by putting off funding your 401(k) you'll never get around to it, work on both goals at once.
The bottom line: If you have a big credit-card balance, wipe it out before you open a 401(k).
Save in a Roth 401(k) OR a regular 401(k)
Don't miss this new chance to lock in tax-free retirement income.
Wish you could forever shelter your retirement savings from taxes, but you make too much to contribute to a Roth IRA? With the recent arrival of the Roth 401(k), you may have, or may soon be getting, a second chance at tax-free income.
Grab it. With a traditional 401(k) you invest pretax dollars and pay taxes when you withdraw your money; with the Roth version you pay taxes on what you put in but nothing on your withdrawals.
About a quarter of employers have rolled out this option, and a majority of plans will likely offer it by 2009. Unlike a Roth IRA, which is off limits in 2008 once your modified adjusted gross income hits $169,000 (as a couple), a Roth 401(k) has no income caps.
Strictly by the numbers: Let's say that you contribute the maximum of $15,500 to your 401(k) and you're in the 28 percent tax bracket. Assuming an 8 percent annual return, you'll end up with $72,245 tax-free in 20 years with a Roth.
If you go with the traditional 401(k) instead, you'll also end up with $72,245 in 20 years, but you'll pay taxes on the withdrawals. At the same 28 percent tax rate, you'd be left with $52,016 you could actually spend.
When you fund the traditional 401(k), however, you shelter $15,500 from taxes. But even if you invest that $4,340 tax savings outside your plan, you'd have to earn well in excess of 8 percent a year to equal your Roth total after taxes.
But wait. Won't your tax bracket drop once you're no longer working? Don't count on it. If you're just starting your career, you'll almost certainly be earning more in 40 years. Even if you're mid-career, you can't assume your tax bracket will plummet.With federal tax rates currently at their lowest levels in decades and the federal deficit growing, it's not hard to imagine Congress raising taxes between now and your retirement. Assume a lower bracket only if you're near retirement and know your tax rate will fall.
You do the math: Use the Roth 401(k) calculator at Dinkytown.net.
Beyond the math: A regular 401(k) has one thing going for it: the up-front tax break. That's why you'll see your disposable income shrink if you switch to a Roth. But for the regular 401(k) even to come close to the Roth as a savings vehicle, you'd have to invest the extra cash that it put in your pocket. Would you?
The bottom line: Unless you are on the verge of retiring and know your income will drop, the Roth wins.
Lease a car OR buy a car
Buying costs less if you own your car till it drops.
With leasing, you always drive a shiny new car, and your monthly payments are lower. So why would you buy?
Strictly by the numbers: A 2008 Toyota Camry will run you just under $27,000 (including taxes and fees). Buy one and finance it with a no-money-down, five-year loan at 6.9 percent (today's average), and your monthly payments will be $526. Over five years, you'll spend $31,560. Say you instead pay $1,000 up front for a five-year lease. Your monthly payment will be $415. At the end of five years, you'll have spent $25,900.
So leasing wins? That's not the full story. If you buy a car, it'll be worth something once you've paid off the loan. Your Camry would fetch about $10,000 after five years, according to estimates by Edmunds.com. That cuts the out-of-pocket cost to $21,560.
But wait. What if you really want a new car? In that case, the gap narrows. Take out a three-year loan on the Camry and your monthly payments would spike to $821, for a total of $29,556. If your three-year-old Camry sells for $14,000, your net cost drops to $15,556.
If you leased, though, your payment would be $485 a month, putting an extra $336 in your pocket compared with the loan. Invest that $336 in a money-market fund paying 4.5 percent, and you'd earn $589 after taxes in three years, assuming a 28 percent tax bracket. Factoring that in, your total lease cost would be $17,871.
Also, the Camry holds its value well. With models that don't, the manufacturer often sweetens the deal by inflating the car's assumed value at the end of the lease term. If you buy the same car, you won't make that much when you sell it, which could tilt the scales in favor of leasing.
You do the math: Use the calculator at Edmunds.com.
Beyond the math:. Leases come with mileage restrictions, typically 12,000 miles a year. Plus, if you ding a leased car, you'll get dinged with fees.
The bottom line: Over the long term, buying costs you less.
Prepay your mortgage OR invest
The feel-good choice isn't necessarily the smart choice.
When some extra cash comes your way, it's tempting to put it toward your mortgage. You'll save on interest and pay off your house earlier. Buying stocks, on the other hand, feels like a risky leap into the unknown, especially now.
Strictly by the numbers: Paying off your mortgage or any loan is an investment, and your return is essentially the interest rate on the loan. If you have 25 years left on a 30-year mortgage with a fixed rate of 6.2 percent and you deduct your interest payments on your taxes, you'll earn 4.5 percent by prepaying the loan (assuming you're in the 28 percent tax bracket).
Now let's say you invest your spare cash in stocks instead. You'll pay a 15 percent tax rate on your long-term capital gains and dividends. So to beat the 4.5 percent return you'd get from prepaying your mortgage, you'd have to earn just 5.3 percent a year on your stocks before taxes.
The odds of your doing that over the 25-year remaining term of your mortgage are excellent: Historically, a portfolio of 80 percent stocks and 20 percent bonds has returned 7.5 percent a year after taxes.
But wait. Paying down the mortgage earns you a risk-free 4.5 percent. That's as good as you'll do with Treasury bonds. True, and if you are investing for a near-term goal and don't want to take any risk, you can make a stronger case for prepaying your mortgage. But if you are investing for a goal that's more than a decade away, you can and should take more risk for a chance at a higher return.
You do the math: To run the numbers on how much money you could end up with by investing, use the savings calculator at CNNMoney.com. To see how much interest you'd save by prepaying your mortgage, use the payoff calculator at Dinkytown.net.
Beyond the math: Of course, all that mortgage debt may be keeping you awake at night, especially if you are worried about losing your job or you're approaching retirement and hope to live on less. You'd be grateful to be rid of that major monthly bill sooner. In that case, prepaying your mortgage starts looking better.
Remember, though, that by prepaying your mortgage, you are reducing your liquid assets. If you suddenly need money, it's easier to sell a mutual fund than it is to pull cash from your home, and you can always pay off your mortgage later with the money you invest now.
The bottom line: Investing wins.
Buy a home OR rent a home
Even in today's crummy market, buying can beat renting if you're in for the long term.
You're relocating, or you're downsizing so you can harvest some real estate wealth. Do you buy right away or rent and wait out the housing bust? To get your answer, consider your monthly expenses, what you'd do with the profits from your old home if you didn't buy and your time horizon.
Strictly by the numbers: If you plan to stay put for at least a decade, buying wins, even if your monthly cash flow is more flush with renting. Over time, rising prices reward home ownership.
Let's say you're 65 and own a $350,000 home in Edison, N.J., mortgage-free. You're moving to the warmer climes of Albuquerque, where similar homes go for $175,000. After commissions and closing costs on both sales, you'll net $152,000. Buy a fixed immediate annuity with that money, and you and your spouse will get $10,500 a year for life.
What if you instead decided to rent in Albuquerque? With the $329,000 you'd clear on the sale of your New Jersey home, you could buy an annuity that pays about $23,000 a year. Even after spending $6,500 a year more in rent than you'd pay in property taxes and upkeep, you'd be ahead by $4,250 a year after taxes.
But if you had bought a home, you can cash in on any future price gains. If you stayed in the new house for 10 years, the price would have to increase by 3.3 percent a year for buying to beat renting (assuming you invest the extra money you would have spent on rent). That's a low bar considering that home prices nationally increased by an average of 6.4 percent a year between 1963 and 2005, according to the research firm Winans International.
But wait. What if housing prices keep tanking? No question, that could happen. That's why you need a long time horizon to ride out the ups and downs. Between 1963 and 2005, the worst 10-year home-price return was 2.5 percent.
You do the math: Use the Rent vs. Buy calculator at Finance.cch.com.
Beyond the math: Owning has other benefits: the comfort of knowing that you'll never be forced to move by your landlord; the freedom to redo your kitchen in any way that strikes your fancy. On the other hand, renting can spare you the onerous upkeep that comes with maintaining a home.
The bottom line: Buying is best as long as you're confident you'll be staying put for several years.
Take Social Security early OR late
Most retirees should hold off four years for the bigger payout.
Collecting Social Security at age 62 cuts your annual benefit by about 25 percent compared with what you'd get if you waited until full retirement age that's 66 if you were born from 1943 to 1959, or 67 if you were born in 1960 or later. To do the math, you need to consider whether you expect to live a long life.
Strictly by the numbers: Say you've just turned 62 and qualify for $17,280 a year now or $23,772 at 66 (in today's dollars). Start early and you'll have collected $69,120 by the time you reach 66. Wait, and higher payments will make up for those missed years in 10½ years.
If you live until at least 76½, postponing your benefits was worthwhile. The odds are in your favor: According to the Social Security Administration, the typical 62-year-old man should live until 80½, while the life expectancy for a 62-year-old woman is 83½.
But wait: When you collect a Social Security check at 62, that's $17,280 you won't have to withdraw from your IRA. Add in the extra tax-deferred growth (assuming 5 percent returns), and your break-even point moves out by three years to age 79½. Even then, odds are you'll live that long.
The math can get even more complicated if you're married. According to new research from Boston College's Center for Retirement Research, the best strategy for many couples is for the wife to take Social Security at 62 and the husband to wait. The reason is that men, on average, earn more and die younger. In this scenario, a wife would take her benefit at 62 and inherit her husband's larger check later.
Finally, waiting to take Social Security assumes you can. Surveys show that 40 percent of retirees are forced into early retirement, through either downsizing or health issues.<
You do the math: Get a more precise handle on your break-even age with the Social Security Administration's Quick Benefits calculator at ssa.gov/OACT/quickcalc/.
The bottom line: If you're healthy and don't need the cash, wait.
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