My Favourite Personal Finance Content (5/18/2020-5/22/2020)

May 22, 2020 by Paul Owolabi Leave a Comment

Below are my favourite Personal Finance Content for the outgoing week.

What Lower Interest Rates Mean for You and Your Wallet – 7 Effects

In this article, Brian Davis examines the effects of lower interest rates on personal finance. He focuses on the impact of lower interest rates on mortgage rates, auto loan rates, housing prices, stock movement, bond rate, etc. He also examines how people can take advantage of the current low interest rates. It is an excellent introduction to how interest rate affects everything else.

Read the article here: https://www.moneycrashers.com/lower-interest-rates-effects

Robo-Advisor vs. Human Financial Advisor – Which is best for you?

Brian Davis does another good job in this article on Money Crashers. Here he examines the pros and cons of human financial advisers and robotic financial advisors (robo-advisors), especially with the latter already gaining traction in the finance industry. He highlights some factors that we need to consider before choosing between the human financial advisor and the robo-advisor. However, he does an excellent job of looking at services that offer a blend of both types of advisors. The article is instructive, comprehensive, and helpful.

Read the article here: https://www.moneycrashers.com/robo-advisor-vs-financial-advisor/

‘I Got Laid Off. What Should I Do With My Retirement Fund?’

This is an episode from Nerd Wallet’s Smart Money Podcast. In this episode, they answer the question of a woman who just lost her job and needs some advice on what to do with her 403 (b) retirement account. Liz Weston and Sean Pyles consider some options she can explore and give important tips to help her navigate the current situation. Whether you are in a similar situation or not, the information in the podcast will be very helpful.

Listen to the Podcast here: https://www.nerdwallet.com/blog/finance/smartmoney-podcast-i-got-laid-off-what-should-i-do-with-my-retirement-fund/

8 Financial Accounts to Open for Your Child to Create Lifelong Wealth

In this article, Brian Davis argues that by opening these eight accounts for their children, parents can teach them more about finance than by giving them instructions. Children, like all of us, learn better by doing rather than cramming formulas and instructions. Some of those accounts include a College Savings Plan, a Checking Account, a High-Interest Savings Account as an emergency fund, and a Roth IRA. Read the article and consider if it is practical for you to implement these steps.

Read the article here: https://www.moneycrashers.com/financial-accounts-open-child/

Types of Retirement Accounts

May 18, 2020 by Paul Owolabi Leave a Comment

Introduction

In previous weeks, we considered how to determine the percentage of your income you should be saving for retirement and how to jump-start your savings. In between those two topics, we also considered how to choose your retirement age and why the age you retire matters. Today, we discuss the different retirement accounts that are available and some tips to help you select a plan that works best for you.

Retirement Accounts

A retirement account is an account where you can invest and grow your retirement savings. In the first quarter of 2020, we looked at the different investment options available for an investor. These retirement accounts help to invest your money in some of these options so you can grow it in preparation for retirement. However, these retirement accounts have different features, which will determine their suitability for different individuals.

Below are the popular retirement accounts that you can create:

401(k)

The 401(k) is the most popular retirement account. It is an employer-sponsored account, also known as a defined contribution plan. With a 401(k), an employee contributes a portion of his pre-tax income for retirement. Contribution to a 401(k) is limited to $19,500 for employees under 50 years of age, while it is limited to $26,000 for employees above 50.

Contributions to a 401(k) are also tax-deferred; this means you will only pay taxes when you make withdrawals on that account. Withdrawing from a 401(k) before the age of 59 ½ will attract a penalty. On the other hand, owners of 401(k) must begin to make withdrawals (required minimum withdrawals) from age 70 ½

Some 401(k) plans allow the owners to take 401(k) loans, which means they can borrow money based on the amount they have in their 401(k) accounts.

An essential feature of a 401(k) is employer matching. Some employers will contribute an amount (a percentage of the employee’s contribution) that matches the employee’s contribution up to a limit. The limit ranges from about 3% to 6% of the employee’s pre-tax income. Let’s take Pat as an example. Suppose Pat earns $50,000 every year, and his employer matches 50% of his contributions. Let’s also assume the employer matches 50% of his contributions up to 5% of total income. This means that if Pat contributes $4000 every year, the employer will contribute $2000 (50% of $4000) as long as it is not more than $2500 (5% 0f $50000).

Some employers use what is called ‘vesting schedule,’ which specifies a minimum number of years an employee must spend with the employer to access the employer-matched contribution.

Solo 401(k)

A solo 401(k) is a retirement account for small business owners who do not have any employees. A solo 401(k) allows the owner of the account to contribute up to $57,000. An account owner who is 50 years or older can make additional catch-up contributions up to $6,500.

Roth 401(k)

A Roth 401(k) is a type of retirement account that combines features of 401(k) and Roth IRA. With this account, you will contribute a part of your after-tax income to the plan. Contributions to the account are not subject to tax as long as you remain in the plan for up to 5 years. Unlike the 401(k), the limits to contributions are stricter with Roth 401(k). For single filers, phase-out begins when your modified adjusted gross income (MAGI) reaches $122,000. You can no longer contribute if your modified adjusted gross income exceeds $137,000. For joint filing, phase-out begins when MAGI reaches $193,000, and you can longer contribute if MAGI is above $203,000

457(b)

It focuses on employees who work for state and local government agencies. Like the 401(k), contributions are limited to $19,500 for workers less than 50 and $26,000 for workers above 50. Unlike 401(k), you can withdraw money from this account before 59 ½ without any penalty.

403(b)

403(b) is a retirement account for people working in tax-exempt and non-profit organizations. A 403(b) allows you to contribute up to $19,500 if you are less than 50 years of age; the limit increases to $26,000 for workers who are 50 years or older. The earnings in a 403(b) account are tax-free until withdrawals (distribution).

IRA (individual retirement account)

All the retirement accounts are employer-sponsored. However, an employee can also decide to open an individual retirement account. An IRA is open for people with earned income (wages, salaries, bonuses, commissions).

Unlike 401(k), the limit to an IRA is $6000 and $7000 for workers 50 years and above. Contributions to an IRA, unlike 401(k), are from after-tax income. However, there will be no tax deduction on the funds until you make withdrawals. IRAs also have a minimum required withdrawal once you are 70 ½.

Roth IRA

Roth IRA is a special form of IRA. The contribution limit is the same as the traditional IRA. The contribution is also from after-tax income. However, unlike traditional IRAs, you will not pay tax on withdrawals, and there is no minimum required withdrawal at 70 ½

You can also make withdrawals from the account before retirement, provided it is after at least five years from the time you made the first contribution.

SEP IRA

SEP IRA is short for Simplified Employee Pension IRA. This retirement account is for business owners with employees and other self-employed individuals. It allows you to contribute 25% of taxable income or $57,000, whichever is less.

The contribution to the SEP IRA is from pre-tax income. Withdrawals from the account are, however, subject to tax. There is a minimum required withdrawal once you are 70 ½ and there is a penalty for early withdrawals (before 59 ½)

Self-directed IRA

A self-directed IRA is similar to a traditional IRA. The difference is in the investment options. While a traditional IRA will invest in stocks, bonds, etc., a self-directed IRA invests in precious metals, real estate, cryptocurrencies, commodities, and limited partnerships. You can open a traditional self-directed IRA or a Roth self-directed IRA.

Simple IRA

Simple IRA stands for Savings Incentive Match Plan for Employees IRA. It is for businesses that have a hundred or fewer employees. For an employee to qualify, he or she must receive at least $5,000 from the company in the last two years and be expected to receive at least $5,000 in the current year. The contribution limit is $13,500, while employees who are 50 years or older have an additional catch-up contribution of $3,000. Employers also match the employee’s contributions.

Contributions to the account are from pre-tax income. Withdrawals are subject to tax, and early withdrawals attract a penalty. Also, you cannot borrow money from a Simple IRA, unlike some 401(k).

You can find some other accounts that are not so popular on the IRS website.

Choosing a retirement account(s)

You will need to consider some essential factors before deciding on a suitable retirement account. Some of them include:

Employee vs. Self Employed

If you are an employee, you have more options compared to the self-employed. A self-employed individual cannot access 401(k), traditional IRA, or Roth IRA. The self-employed can only access accounts like the Solo 401(k) and the SEP IRA. Therefore, the first important consideration is to understand the accounts for which you qualify.

Employer Matching

If, as an employee, your employer matches your contribution to the 401(k) (or whatever employee retirement account you have), then you have to max out your contribution to the 401(k). In the example we considered, Pat was able to get $2,000 from his employer. However, from our calculations, the maximum contribution the employer can make is $2,500. Why leave that $500 on the table? Instead of contributing $4,000, Pat can increase his contribution to $5,000 to take full advantage of the employer’s contribution.

In the absence of employer matching

In the absence of employer matching, you may need to choose between a 401(k) and an IRA. This choice assumes that you cannot fund both retirement accounts at the same time. In that case, you will need to consider some factors to decide if you should go with a 401(k) or an IRA.

Fees: Will you incur higher fees with the 401(k) or the IRA? It is essential to compare the fees associated with both types of retirement accounts to determine which is more profitable.
Withdrawals: You should also consider the withdrawal policies. 401(k) will allow you to make withdrawals (subject to a penalty before age 59 ½). However, you would want to know if the 401(k) allows the loan option – where you can borrow money from your account. With IRA, withdrawals do not incur any penalty. The accessibility of funds is another important factor you should consider.
Investment options: You should consider where they are investing your retirement funds. If an IRA gives the ability to invest in a wider variety of funds compared to a 401(k), you need to consider that fact before deciding.
Tax: How vital is tax-deduction to you? With a 401(k), you will get a tax deduction since you are contributing from pre-tax income. With IRAs, you will contribute from after-tax income and get no tax deduction. However, with Roth IRA, you will not pay tax at withdrawals (contra traditional IRA and 401(k)). You also need to consider how vital tax deduction and tax-free withdrawals are to you.

This is especially crucial if you plan to leave the money in your retirement account for other beneficiaries. In that case, Roth IRA that allows tax-free withdrawals with no minimum required withdrawal may be a better consideration than a 401(k) or traditional IRA.

Professional Management: If you choose an IRA, you may need to pay for professional management if you do not have the time or skills to manage your funds. If a 401(k) provides professional management for free, that is an important factor you need to consider.

No employer matching but you can fund two accounts

If there is employer matching and you can fund two accounts, ensure you max out your 401(k) before funding an IRA.

However, if there is no employer matching, you will need to use the factors in the previous section to determine which of the accounts will be the primary and the one that will be the secondary. You will also need to choose between the traditional and Roth IRA. Alternatively, you may decide only to use IRAs and set up two types of IRAs.

If you set up both the traditional and Roth IRA, keep in mind that you cannot exceed the $6000-$7000 limit for the two accounts combined. In other words, you cannot contribute $6000 to each account. It’s the total contribution to both accounts that must not exceed $6000.

Catch-up

The catch-up feature is useful for those who have not accumulated enough nest egg for retirement. It applies to those who are 50 years or older. For 401(k), it extends your limit by $6500 ($26000-$19500), while for IRAs, it only extends it by $1000 ($7000-$6000). The difference between an additional $6500 (401(k)) and an additional $1000 (IRA) is another thing you may want to consider.

Conclusion

It’s crucial to understand the available retirement accounts and the essential factors to consider before making a choice. You should give enough thought to this, reviewing your financial plan and retirement goals.

My Favourite Personal Finance Content (5/11/2020-5/15/2020)

May 15, 2020 by Paul Owolabi Leave a Comment

These are my favourite personal finance content for the outgoing week.

5 Financial Lessons Millennials Are Learning During The Coronavirus Pandemic

Katelyn Van Pelt, writing for Money Under 30, examines some five key lessons that millennials are learning about money during this period. Katelyn affirms that millennials are learning about the importance of emergency funds, the reality of essential and non-essential spending, the need to teach kids about finance, the importance of investing in retirement, and how to take advantage of low-interest mortgage rates during this period.

She examines why these five lessons are crucial to sound personal finance.

Read the article here: https://www.moneyunder30.com/financial-lessons-millennials-are-learning-during-the-coronavirus-pandemic/

The Top Ways To Get Student Loan Forgiveness

In an article for The College Investor, Robert Farrington explains all the available options a student can explore to get student loan forgiveness. He believes that at least 50% of borrowers can have all or part of their loan canceled through these programs. He divides these options into different categories, including repayment plan based student loan forgiveness, income-based repayment, PAYE, and revised PAYE, income-contingent repayment, public service loan forgiveness, among many others.

It is a very comprehensive article that will be especially useful for students.

Read the article here: https://thecollegeinvestor.com/578/ways-to-get-student-loan-forgiveness/

8 Steps to Research a Company to Invest in

This video goes through eight simple steps that every investor can use to research a company. The steps include pulling out the business section of the 10k, examining the Management Discussion and Analysis (MD&A), conducting a financial statement analysis, examining the company presentations and earnings calls, performing competitor analysis, determining the fair value of the company, identifying the drivers of the stock, and waiting for a buying opportunity. He uses Goldman Sachs as an example to illustrate the eight points.

Watch the video here: https://www.youtube.com/watch?v=fGVtypWv04Y&t=190s

Should You Invest During COVID-19 – What To Consider

In this article, Lance Cothern, helps investors to consider some important factors before they decide to invest or not invest during this period. He gives some reasons for the interest in investing during this time, examines some important considerations for those who want to invest, and lays out some principles for profitable investments.

Read the article here: https://www.moneyunder30.com/investing-during-covid-19

6 Retirement Planning Challenges for Freelancers and Entrepreneurs

G. Brian Davis, writing for Money Crashers, examines six key challenges that freelancers and entrepreneurs face regarding retirement planning. He identifies those challenges and gives some tips on how freelancers and entrepreneurs can navigate them. The challenges include the absence of employer retirement benefits or plan, double FICA taxes, health insurance, absence of paid time off, inconsistent income, and less income security.

The tips that Davis gives are practical; they will be helpful to every freelancer and entrepreneur.

Read the article here: https://www.moneycrashers.com/retirement-planning-challenges-freelancers-entrepreneurs/

My Five Favourite Personal Finance Content (5/4/2020-5/8/2020)

May 8, 2020 by Paul Owolabi Leave a Comment

These are the top personal finance content (blogs and videos) I consumed in this outgoing week. I hope you find some of them useful.

14 Numbers You Need to Know When Investing in Real Estate Deals

G. Brian Davis, writing for Money Crashers, explains fourteen essential numbers that every real estate investor must know when making investment decisions. These numbers include cash-on-cash value, loan-to-value ratio, after-repair value, closing costs, renovation costs, gross rent multiplier, cap rate, monthly cash flow, appreciation, population growth rate, job growth and unemployment rate, price-to-income ratio, and price-to-rent ratio.

Brian follows a beneficial structure. The first section explains the numbers about which every real estate investor should care. The next two sections focus on numbers relevant to flippers and income investors, respectively. The last section then highlights numbers that deal with housing market fluctuations.

Read the article here: https://www.moneycrashers.com/real-estate-investing-deals-numbers/

5 Pieces of Investment Advice for Real People

Alana Benso, writing for Nerd Wallet, curates five valuable investment advice from expert investors. The five pieces of advice are: take advantage of employer-matching dollars (401-k and 402-b), start early, have a financial plan, do not try to predict the market, and take a long view.

Benso also gives specific tools that you can use to implement these five steps.

Read the blog here: https://www.nerdwallet.com/article/investing/investment-advice

Analyzing Warren Buffett’s Portfolio

Simranpal Singh, in this video, examines the top five stocks in Berkshire Hathaway’s portfolio. He analyzes these companies and calculates their intrinsic values. Based on the calculation, he decides whether the company is overvalued and undervalued.

The video is an interesting one, and it includes links to the valuation methods he uses for evaluation.

Watch the video here: https://www.youtube.com/watch?v=TCo7DQmItIY

How to Pay Rent When You Can’t Afford It

Melissa Lambarena, writing for Nerd Wallet, offers some options that people who find it difficult to pay rent during this period can explore. He divides the article into the free options, the options that involve dipping into your investments, and those that involve taking on debt. Some of the former include talking to the landlord, calling nonprofits and religious organizations, applying from grants, and asking help from family or friends. Under the second option (investment), he mentions selling some stocks or withdrawing from a 401(k) account. The last option should be choosing the least expensive high-interest debt.

Melissa’s article is very practical and helpful. Ranking these various options from the free to the most ensures that people will consider the free options before exploring the more expensive options.

Read the article here: https://www.nerdwallet.com/article/credit-cards/how-to-pay-rent-when-you-cant-afford-it

How to Calculate the Intrinsic Value of a Stock

Simranpal Singh, in this article, goes through the valuation of a company’s stock using the DCF valuation model. He employs a systematic approach that makes it easy for you to replicate the calculations on any stock. After explaining the process, he uses Apple’s stock as an example to illustrate the process further.

Watch the video here: https://www.youtube.com/watch?v=m6XlMnAkvBc&t=15s

How to Jumpstart Your Retirement Savings

May 5, 2020 by Paul Owolabi Leave a Comment

Introduction

A survey by TD Ameritrade found that about 28% of Americans in their sixties have less than $50,000 in savings. In the same study, they discovered that two-third of Americans 40 years and above have less than $100,000 in retirement savings. More surprisingly (at least to me), 20% of those between age seventy and seventy-nine have less than $50,000 in retirement savings.

These statistics show that many Americans (and people in other countries) find it challenging to save for retirement. It may be one of the reasons why many are working late into their 70s even though they would prefer to retire before then. For those who would want to retire earlier, this is a significant hurdle. Even for those who would want to retire late, they will still have to retire at the end.

All of these are happening at the same time that current reports are showing that the working population in the United States and other European countries is shrinking. Currently, the ratio of active workers to retirees in the United States is 5:1. However, USA Today projects that by 2050, this will be less than 3:1, which means there will be fewer people supporting the social security system.

The implication of all of these is that you need to jumpstart your retirement savings whatever time of life you are in at the moment. You can’t work forever. You can’t trust in the social security system forever. It’s time you begin to take more personal responsibility for your retirement savings.

Monthly Saving Goal

In a previous article, we went through the intricacies of deciding how much you should be saving for retirement. If you follow that process and practice it, you will have a percentage figure you should be targeting.

In the example from that post, Dave needs to save 5% of his annual income for retirement. The next thing is to break this figure to a monthly target. Since Dave earns $50,000 every year, that’s a yearly saving requirement of $2500 and a monthly saving requirement of $208 (you can check all the assumptions we made for Dave).

The purpose of this example is to give you an idea of how to calculate the amount you will be setting aside for retirement every month to achieve your retirement goals. Figuring out a monthly amount will make it easier to achieve your retirement savings goals.

The clearer your goals, the easier it is to accomplish.

Achieving the Monthly Saving Goal

Saving is one of those things that are easier said than done. It is easier to create a savings target but more challenging to stay true to them. However, creating those targets is always a good place to start. What are some steps you can take to achieve your monthly savings goal and jump start your retirement savings?

General Guidelines

Creating a Budget

Setting up a budget is always the first step to achieve any financial goal. Last year, 33% of Americans didn’t have a budget. Budgeting is essential because ‘he who fails to plan, plans to fail.’ It is an excellent way to keep track of income and expenses. You can see very clearly where your money is going. Without a comprehensive and robust budget, it will be more difficult to save money. When you budget and stay with the budget, you can identify opportunities for savings.

Max out your savings by trimming down expenses

If you look at your expense items with critical eyes, you will always find opportunities to cut down on many unnecessary things. We all have those things we should not be spending money on at all or, at least, spend as much money on as we currently do.

This is one area where it is difficult to set aside hard and fast rules. What is essential to Mr. A may be unimportant to Mr.B. You can check this article by LifeHack for some guidelines. However, consider your life situation before adopting any suggestion. That said, try to be as ruthless as possible.

Setting up an emergency fund

The next thing to do is to set up an emergency fund. Many people find it difficult to save because of debt. However, we can avoid many of the debts we incur if we had an emergency fund. An emergency fund is money you set aside to cater for emergencies like job loss, slide in business income, and unexpected medical bills.

An emergency fund can be your monthly expenses for three to six months, depending on factors like job stability, among others. It should also be in an investment channel that is liquid (easy to convert to cash).

Setting up an emergency fund will prevent you from incurring additional interest payments on loans.

Setting aside money for expected large expenses.

Similarly, if you expect to incur a large expense in the next twelve to eighteen months, you will do well to set aside money for such expenses. If you don’t set aside money for those expenses, they will lead to more debt when it is time to incur them. By setting money aside for them, you can pay for them without incurring debt.

Debt Snowballing

If you already have some debt, you need to pay them off. As long as the debt is lingering on your budget, it will be harder to achieve your retirement savings goals. To do this, you can use the debt snowballing process. Below is what I wrote about this process last year:

“Write out all your bad debts in a sheet with a column for amount owed, interest rate charged, and minimum payment. Start with the debt you can easily pay off to get some momentum.

To carry out this process, you need a surplus, and you need to ensure the amount you currently apply towards payoff will continue to serve that purpose until you have cleared the account. The surplus is an amount you can pay above the minimum payment of your debts. You can get the surplus by ensuring that it is only your necessary expenses you are incurring every month.

Start with the smallest debt, pay the minimum balance, and then use the surplus to pay the debt. It is good if the debt is paid off by the surplus. If the surplus remains after you pay off that particular debt, apply it to the next debt.

As you pay off one debt, you move to the next debt with that surplus amount, and then the next.

Revel in the success, then repeat it: As you clear off the lower amounts, use the momentum to go to the higher amounts until you pay off all the debts. Celebrate the little victories, but don’t over celebrate with something expensive. In a few months (depending on your debt size), you should be completely free from debt. Then go back to read the section on how to avoid bad debts in the first place.”

Spend what is remaining

George Clason’s The Richest Man In Babylon contains some of the best strategies to achieve your saving goals. One of the concepts he dwelt upon is “spend what is remaining.” Instead of saving what remains after spending, spend what remains after saving. The latter approach will help you to achieve your saving goals and develop the discipline you need to cut down unnecessary expenses.

Avoiding Impulse Purchase

If you are very prone to impulse purchases, you might need to stop going out with your credit card (if you need to have one). You may need to adopt the cash-only lifestyle to prevent you from incurring debt by buying things you can’t afford (and don’t need). Whatever discipline you need to adapt, stay faithful to your budgeting, and put an end to impulse purchases.

Re-evaluating Mortgage

Arguably, mortgage constitutes the largest portion of expenses for the average person. One of the things you have to consider on the road to achieving your retirement savings target is your mortgage. Do you need to live in your current location? Do you need the type of house in which you are currently living? Is it possible to make do with a cheaper home or the same kind of house in a different location? Are you paying too much in mortgage than you should?

Considering these questions may lead to a process that can help you cut down on your mortgage obligations.

Specific Guidelines

Maximize contribution to employer matching 401(k)

We’ll be looking at these different retirement accounts later on. However, at this point, it is important to consider maximizing contribution to your employer matching 401(k). If you have access to this account, make maximum use of it. An employer matching 401(k) allows your employer to match the contribution the employee is making into the retirement account. The typical payment to a 401(k) is 6% of the employee’s salary. Whatever you contribute, the employer will either match a portion of it (50%) or match the whole amount. (100%)

There is a maximum contribution value of $19,000 on a 401(k). This means you can’t contribute more than $19,000. If you have access to a 401(k) employer match, then, by all means, try and meet this maximum amount. The more you put in, the more your employer will match.

For example, if you earn $60,000 annual income and contribute 6% to 401(k), that will be $3,600 per year. Let’s assume your employer matches 100% of that amount. You will have $7,200 at the end of the year. Supposing you raise your contribution to $6000 instead of $3,600, you will have $12,000 at the end of the year.

If you are 50 and above, you can contribute up to $25,000 every year to your 401(k).

Conclusion

Whether you want to retire early or late, you will retire one day. To ensure you have the financial resources to retire well, you need to start setting and meeting your monthly retirement savings target. It may be a difficult process to begin with, but it is worth all the efforts. Wherever you are with your savings, you can jumpstart it and be on the road to the retirement of your dreams.

Choosing your Retirement Age

April 28, 2020 by Paul Owolabi Leave a Comment

Introduction

In a previous article, we examined how you can determine the amount you need to be saving now in preparation for retirement. One of the factors that will affect that decision (as you saw) is the age of retirement.

Choosing a retirement age is one of the retirement decisions that people considering or planning for retirement will have to make. This decision often involves consideration of many financial and non-financial factors. Whatever decision you make, there will always be a trade-off. Choosing a retirement age is one area where individual needs and differences come to play.

How Retirement Age Impacts Retirement Income

The age you retire will affect the income that will be available to you at retirement via Social Security benefits. You are not eligible for social security benefits until 62. Consequently, if you retire before the age of 62, you will have to remove social security as one of your income sources until you are 62.

Also, if you begin to claim your retirement savings before the age of 66, you will not have access to the full amount. You will probably get only 75% of the full amount. Your spouse will also get only 35% of the benefits instead of 50% if you wait until you are 66. The reason for this reduction is that you will be claiming the benefits for a longer time. The person who begins to claim at 66 will have lesser time to make claims, which increases what he or she gets per claim. On the other hand, the person who begins to make claims by 62 will have more time to make claims, which reduces what he or she gets per claim.

Furthermore, if you wait until you are seventy, you will get the highest possible social security payment.

The bottom line? The longer you wait to retire, the more retirement income you will have due to higher social security benefits.

Retirement Age and Retirement Savings

However, social security benefits are not the only source of income at retirement.

If you remember from the last article, the retirement income you need from savings is 80% (can be more or less) of your annual pre-tax income minus income from social security benefit. Therefore, if the money from social security benefit reduces, income from retirement savings have to increase to match the retirement income you need. If you choose to retire early, you will need to increase income from retirement savings. (we assume there will not be other income sources for the sake of simplicity).

Therefore, the earlier you retire, the more money you will need in your retirement accounts during retirement. Alternatively, you can choose to augment the shortfall by income from part-time work if that will not defeat the reason you want to retire in the first instance.

Retirement Age and Financial Independence

Another factor when it comes to deciding on retirement is financial independence. Many people want to achieve financial independence as early as possible. Because of that, they prefer to retire as soon as possible. It bears repeating here that people who seek financial independence seek it for different reasons. It does not necessarily mean the person wants to spend all day sleeping or binge-watching Netflix. Instead, some people want to devote themselves to some causes in the world they are passionate about without having to consider if it pays income – or how much it pays.

Therefore, the pursuit of financial independence can make some people retire earlier than others.

Retirement Age and Medical Insurance

Medicaid does not set in until the age of 65. Therefore, for those who want to retire earlier than this, one consideration is their capacity to set up personal medical insurance before Medicaid sets in. In this case, the retirement savings will even need to be higher.

Other Factors

Other factors determine when people choose to retire.

Boredom

Many people decide to retire late because of the fear of boredom. These are business owners and working professionals who cannot imagine life outside the corporate world or the business management sphere. People in this category will choose the latter end of the retirement line (70). Some of them may even decide to forego retirement. For these people, it is not a financial decision but a matter of what they love to do.

Others have other things they would love to do at retirement, and boredom is the last thing with which they concern themselves. Those in this category will most likely choose an earlier retirement age.

Standard of Living

Some people are afraid their standard of living will drop if they retire early. This is especially true for people with low retirement savings. They feel they can’t meet up with the income they need at retirement. Therefore, they prefer to wait out retirement or forego it entirely. They would instead take up a less demanding part-time job as their age advances.

Saving Habit

Some decide to retire late because they can’t get themselves to develop the saving habit they need to require earlier. They are different from those who find themselves with low retirement savings at a specified period. It might not be too late for these people, but they can’t just get to saving.

Motivation

There are different motivations for retirement. As such, people have different preferences when it comes to the age of retirement. Some who love their job may hasten retirement. Those who love their job may delay (or forego) it. Those who have things they want to pursue at retirement different from their current job will retire earlier than those who do not.

Making a Choice

What works for A will not necessarily work for B. Every individual need to pull these factors together and make a decision.

If you want to retire before 62

Some of the questions include:

Do you have enough retirement savings to cope without social security?
Do you have a pursuit that will occupy your time during retirement?
Can you fund personal healthcare insurance? (Medicaid does not set in till 65)
If retirement savings is not significant enough, are you willing to lower the standard of living or do part-time work?
Can your savings habits produce the retirement savings you need during retirement?

If you want to retire before 65 but after 62

Some of the questions include:

Do you have enough retirement savings to cope with reduced social security payment?
Do you have a pursuit that will occupy your time during retirement?
Can you fund personal healthcare insurance? (Medicaid does not set in till 65)
If retirement savings is not significant enough, are you willing to lower the standard of living or do part-time work?
Can your savings habits produce the retirement savings you need during retirement?

If you want to retire by 66

Some of the questions include:

Do you have the health to keep working until 66?
Do you still enjoy doing the work you are doing?

If you want to retire by 70

Some of the questions include:

Do you have the health to keep working until 66?
Do you still enjoy doing the work you are doing?

Conclusion

Choosing a retirement age is both a science and an art. It involves many personal factors, and only you can decide the age that is right for you. You must consider all the financial and non-financial factors before making a decision.

How Much Should I Save for Retirement?

April 21, 2020 by Paul Owolabi Leave a Comment

Introduction

In the previous article, we looked at the growing interest in financial independence. We considered how that affects retirement. In this article, we will seek to answer one of the pertinent questions when it comes to retirement – how much should I save for retirement.

It is important to state at the onset that retirement is a very personal affair. This is one area where you have to recognize the ‘personal’ in personal finance. Many of the decisions will depend on your situation and preferences.

How much will You Need in Retirement?

The first step when it comes to discussing how much you should save for retirement is to determine how much you will need at retirement. It is only logical that the money you will need to save will depend on how much you will need.

According to Fidelity, you will need between 55%-80% of your pre-tax annual income at retirement. What this means is that when you retire, you will not need to replace 100% of your current pre-retirement income. If Dave earns $50,000 annual pre-tax income prior to retirement, he will only need between $27,500 (55%) and $40,000 (80%) in retirement.

You will only need a percentage of your income and not the full amount because of some expenses that go away or decrease at retirement. At retirement, you will no longer contribute to retirement. You will pay lesser taxes, lesser insurance, and incur lower daily expenses (transport and clothing, for example).

There is an inverse relationship between current income and retirement ‘income’ (By retirement income, I mean the amount you need during retirement). The higher your current income, the less the replacement rate ceteris paribus), vice versa.

You can do the calculation on your current income or what you expect your income to be in the year preceding retirement. To be conservative, you should do the calculation on your current income (if you expect a significant increase in your income over time).

Also, if you earn less than $100,000 annually, it is better to choose 80% of annual pre-tax income as the amount you will need at retirement. This table from Fidelity gives you the percentage you should select for every income bracket. However, to be conservative, you can stick to the 80% rule.

What Percentage of ‘Retirement Income’ Should Come From Savings?

Now that you know how much you will need at retirement, the next thing is to discuss what percentage of that amount will come from your nest egg (savings). To know this, we have to consider two critical factors.

Expected Income

Retirement savings is not your only source of income at retirement. There is Social Security. Depending on your job, there is also pension payment. Some people may also decide to earn some part-time income.

These three income sources will cover a certain percentage of what you need at retirement. Let’s continue with the example above. Let us say Dave needs $40,000 (we choose the 80% rule) annually during retirement.

Dave can expect $17,500 (35% of $50,000, the pre-retirement, pre-tax annual income we used in the calculation) from Social Security based on his income levels. Social Security payment varies inversely with income levels. The higher your income levels, the less you get, vice versa. Another factor that determines what you expect from Social Security is the age you retire. The earlier you retire, the lesser the amount you can expect from Social Security during retirement. The above calculation assumes Dave retires at 67. If he retires before 67, Social Security will fall. If he waits until 70, it will increase. If you retire before 67, attributing 55% of retirement income to retirement savings will be a conservative estimate.

If we assume that Dave will not work part-time and his work does not pay pensions, this means he will need $22,500 ($40,000-$17,500) at retirement, which is 45% of the total amount he needs at retirement.

It is a common rule that you will need your savings to cover 45% (if you do not retire before 67) the annual ‘income’ you need during retirement. However, this rule works only if you do not expect money from pension and part-time work. Even if you do, it is still a good practice (to be conservative) to use 45%.

Expected Expenses

Another factor to consider is the expenses you incur during retirement. As a rule of thumb, your expenses will decrease during retirement. However, this will depend on your lifestyle. Some people may pursue a more expensive lifestyle, like traveling around the world or large donations to charitable causes.

If you expect to be in this situation, you can increase the percentage you need from retirement savings or change retirement income to 100% of annual pre-tax income.

How much Should You Save?

Now that you know your retirement ‘income’ and the amount you need from savings, you can now determine how much you will need to accumulate in savings by retirement and how much you will need to be saving right away.

Some Approaches

The 4% Rule

The first and simplest approach is the 4% rule. All you need to do is divide the retirement income by 4%. The resultant figure is how much you need to have in savings at retirement. (The 4% rule assumes a return on investment of 5% after taxes and inflation)

Dave will need $1,000,000 at retirement ($40,000/4%). The 4% approach does not consider Social Security. It assumes that there will not be Social Security Payment. In that sense, it tries to be even more conservative.

We can tweak the formula to account for Social Security Payment. In that case, Dave will need only $562,500 ($22500/4%). If you want to be more conservative, you can choose the former figure.

Annual Income Multiples

This approach calculates the money you need to save to meet a particular annual income multiples target at different periods.

One of these approaches requires you to save an amount that will be 1X your annual income by age 30. You accomplish this by saving 15% of your yearly income beginning at 25 and investing 50% of that amount in stocks.

In Dave’s case, he will need to have $50,000 in savings at age 30 by saving $7500 (15% of $50,000) every year from age 25.

At 40, you will need to have 2X your annual income. It will be 4X at 50, 6X at 60, and 8X at 67.

In another approach, you will accomplish 2X by 35, 3X by 40, 4X by 45, 5X at 50, 6X at 55, 7X at 60, and 8X at 65. However, in this approach, you will save 25% of your annual income during your 20s.

Retirement Calculators

An alternative is to use retirement calculators. These calculators will give you more personalized calculations. They will put many essential factors to play to determine how much you need in retirement savings at retirement and how much you need to be saving. Below are some of those calculators:

Nerd Wallet: They factor in your current total savings, age, pre-tax income, and monthly savings. The calculator will return how much you will need to save and how much you will save based on the data inputs. It will also return a percentage value to see how close you will be to what you need at retirement (what you will save/what you need).
Millennial Money: It requires data inputs like current retirement savings balance, date of birth, target retirement age, safe withdrawal rate, monthly contribution, investment growth rate, inflation rate, the expected tax rate on retirement account withdrawal, and expected annual retirement expenses.
Vanguard Capital: Inputs include how many years you want your savings last, current savings balance, and monthly expenses. The calculator assumes a 50% investment in stock, 30% investment in bonds, and 20% investment in cash. The result will show you a probability that your savings will last.
Bank Rate: Inputs include current age, age of retirement, annual income, annual retirement savings, current retirement savings account balance, expected income increase, retirement income, and the expected years of retirement. The output will be when your retirement savings run out. You can also tweak the return on investment estimates (before and after retirement), the inflation rate, and the percentage of current income (remember the 55%-80%) that you will need in retirement. There is also an option to include marriage and Social Security Payment as a factor.

You can check other retirement calculators here or here.

Pulling It Together

So which of these approaches is best? I believe you should use a blend of the annual income multiple approaches and the retirement calculators. The retirement income we calculated will be a prominent figure in many of these calculators. Use the 4% rule, the annual income multiple, and some blend of the retirement calculators.

With the 4% rule, you will get a figure for how much you need to have in savings at retirement. The annual income multiples approach already have a set saving rate (15%, for example). If you are comfortable with that rate, you can use this approach. The advantage of the calculators is that you can easily simulate. What if you are saving 10% instead of 15%? What if you now want to retire earlier? You can easily factor in these questions with the calculators.

My personal opinion? The Bank Rate calculator is the best approach. Input all the figures (including the ones we have shown you how to calculate above) then start tweaking the annual retirement savings % until you come up with a percentage where your retirement savings will last you for the years of retirement income (how long you want to keep taking from the retirement savings). If you’re going to retire at 67 and expect to live to 90, the years of retirement income will be 23. Keep tweaking the retirement savings percentage until the calculator tells you your savings (based on the data inputs) can last until 90.

The resultant percentage figure that gives you that green light is how much you need to be saving every year.

If the % that gives you that green light is too high, you can tweak other factors (inflation rate, return on investment, and increase in your income, for example). However, try to be as conservative in your estimates as possible. Also, do not be surprised that you can save more than you think.

Concluding Dave’s Example

Let us make the following assumptions for Dave.

Age: 40
Years of retirement income is 18 (live until 85 years).
The balance on his retirement is only $100,000.
Annual retirement savings: 10%
Retirement age: 67
Increase in Income is 0% (conservative)
Rate of return before retirement is 5% and after retirement is 4%
An inflation rate of 2%
Married: Yes

Without Social Security Payment, all of these inputs give us $611,135 retirement savings, which will last for 18 years.

If we include Social Security Payment, the money will last Dave even beyond 85. At 85, he will have more than $900,000 extra.

If we add five more years to the years of retirement income, Dave will not have more than $1,000,000 at 90.

If he does not want all these extra money, he can tweak the annual retirement savings down a bit. If we set it at 5%, Dave will now have only $755,431 at age 90. If his retirement is 100% of current annual income, he will still have more than $200,000.

Therefore, this means that Dave only needs to save 5% of his annual income (towards retirement).

N.B

However, I will still advise you to talk to a professional to get some expert advice before making your conclusions.

Conclusion

One of the fundamental things when it comes to retirement is deciding how much you need to be saving every year (as a percentage of your total income). When you know this figure, it will make your retirement planning easier and smoother.

Retirement and Financial Independence

April 14, 2020 by Paul Owolabi Leave a Comment

Introduction: Why we look forward to Retirement

The topic of retirement is a popular and peculiar one. Many people look forward to their retirement for different reasons. As much as work is an essential part of our humanity, we still look forward to retirement. Maybe for many people, retirement is all about putting a stop to work and enjoying untold leisure and entertainment (that they could not enjoy while in the working population).

However, for many people, retirement is not about ceasing from every productive activity or spending time in idleness. It is about doing a work they are passionate about without caring about the income. For some, it is about finally starting a business they like. Many people look forward to it as an opportunity to finally give themselves for some charity work, mission trips, or advocacy. A large number of people just want to travel around the world.

In a survey by AAG, 64% of women and 47% of men respondents will spend their time in retirement volunteering.

The Growing Interest in Financial Independence

There is a growing interest in financial independence in our modern world. The reason, I believe, is tied to the same reason many people look forward to retirement – a desire to finally do what they are passionate about irrespective of the income.

In the same survey by AAG, 46% of respondents say they will retire immediately if they win the lottery. Twenty-one percent of respondents will leave their current job without retiring. While this is not the main reason for retirement, I believe it is a major one.

Today we hear a lot of talk about people trying to achieve financial independence in their 30s or 40s. Many people want to retire in their 40s or 50s. As I said earlier, for many of these people, the goal is not to spend the rest of their lives in endless leisure and entertainment.

Retirement Planning

Anticipating retirement involves lots of planning. However, one of the most critical plans when looking forward to retirement is financial planning. There must be a plan in place to achieve financial independence before or at retirement. Whatever be the reason you are looking forward to retirement, it is easier for you to achieve those goals when you attain financial independence.

Therefore, while it is essential to make plans for where you want to do, places you want to explore, and what you will be doing during retirement, financial planning must take a central stage.

Also, the earlier you start, the better. If you start planning for retirement now, you will be able to achieve your goals earlier with less stress. If you are already saving for retirement via your employer, you still need to think through many essential things. Many people have retirement accounts with their employers, but they do not even have a clue how it works or whether the present structure of things is what they need to achieve their goals.

If there is one thing we have emphasized on this blog, it is the importance of planning. Every decision and every step must flow out from a well-documented and thought out plan. You must not leave your finances to chance.

Conclusion: The Journey to Retirement

If you want to attain financial independence at retirement, you must take the journey to retirement seriously. It begins from now until the time you plan to retire. To achieve the life you want, you must take specific steps now. To reap a harvest in the future, you must do the hard work of planting and nurturing in the present.

This article is an introduction to our theme for this quarter: planning for retirement. In the weeks to come, we will look at different retirement topics. The goal is to help you attain financial independence so you can live the life you want (and deserve) when retirement comes knocking. Stay tuned.

Monitoring and Evaluating your Investments

March 31, 2020 by Paul Owolabi Leave a Comment

Introduction

In these series of articles on investment, we have looked at why you should invest your money, how to get money for investment, and the different investment vehicles you can deploy. If you missed any article in the series, do well to read up.

As the quarter ends, I want to end this series by explaining how to monitor and evaluate your investments.

It is not enough to make smart investment decisions and build up a good portfolio. Remember that one of the things I emphasized in this series is the need for you to have concrete investment goals. Consequently, you need to monitor the performance of your portfolio with your investment goals as the benchmark. The question you are asking is, “does the performance of my portfolio align with my investment goals?”

If this whole process of monitoring and evaluating your investments seems too technical or complicated for you (it is not), you can employ a portfolio manager or investment manager to handle it on your behalf.

However, even if you decide to do this, as a responsible investor, you still need to monitor and evaluate your investments.

Monitoring your Investments

How then do you monitor and evaluate?

It starts with monitoring. Every brokerage firm you invest with will send you regular valuation statements. These valuation statements are statements of account that show your current investments, their current value, the cost of the investments, returns on investments, and the weight of each investment to your total investment.

Mutual Funds will also send you a regular valuation statement. Banks will also send periodic statements of accounts for your savings accounts.

These statements are a good place to begin.

Certain tools help to monitor your investments from a central location. Morning Star provides one of these tools. Personal Capital also provides a tool that helps with this. By uploading or manually inputting your investment accounts, you can keep an eye on them from the central location.

Evaluating Investments: Useful Criteria

What should you look for when evaluating your portfolio?

There are many criteria that you should keep an eye on. However, it is the financial goals that you set that will guide you in this entire process.

Diversification

One of the absolute essentials is the diversification of your portfolio. The question here is whether there is sufficient diversification to manage risk.

Some of the things you should consider include:

Are your stock investments too concentrated in one sector of the economy? When your stock investments are too concentrated in one sector, you will get hurt in a significant way if the sector experiences a downturn. Take a long look at your stock investments and examine if there is a sufficient level of diversification at this level.

While trying to diversify your investments across different sectors of the economy, keep your investment goals in mind. You need to have clear criteria that a stock must meet before you purchase it. What you are trying to do here is look for stocks that meet those criteria in different sectors rather than a single sector.

Fixed-Income diversifications: Diversification is not only for stocks. When you invest at the level of fixed-income securities, there is also a need for diversification. We mentioned this when we talked about bonds and certificates of deposits. Different fixed-income securities offer various benefits. Having a good portion of them rather than a single one will help reduce the risk in your portfolio. If you buy some corporate bonds, you may balance the risk with some federal or municipal bonds, treasury bills, or CDs.

Another important point here is tying down cash. Diversification also means investing in assets that will mature across different time horizons. Such type of diversification helps you to reduce the risk of exposure to interest rate variations (especially bonds and CDs). Use the bond ladder or the CD ladder system to achieve this.

Mutual Funds diversification: If you decide to buy mutual funds rather than individual stocks, there is also a need for diversification. You need the right balance between equity funds and fixed-income securities funds. Similarly, you should consider investing in index funds that track the performance of an index as a way of minimizing risk and cost.

Are your investments too localized? Some investors have all of their investments in a single country. The problem with that is that when the country experiences a recession, all your investments suffer. However, when you put some of your investments in foreign markets, you reduce the risk. Only a global financial crisis can deal a huge blow to your portfolio. Review your portfolio. Look for ways to diversify across markets. Hold on to your criteria and look for investments in other countries that match.

Courtesy: https://www.jagoinvestor.com/2008/04/what-is-diversified-portfolio-and-how.html

Structure

Finding the right portfolio structure is essential. What mix of equity to fixed-income securities should you target?

The primary factor to consider here is the proximity to retirement. The farther you are from retirement, the more the equity you should purchase (you have enough time to take more risk in anticipation of higher returns). The closer you are to retirement, the more the fixed-income securities you should purchase (the lesser the risk you can take with stocks).

It is hard to put down a hard and fast rule here. It depends on your risk profile. Dana Anspach, writing for The Balance, gives the following advice:

Ultra Aggressive: 100% in stocks.
Moderately Aggressive: 80% in stocks, 20% in bonds and cash.
Moderate Growth: 60% in stocks, 40% in bonds and cash.
Conservative: 50% in stocks, 50% in bonds and cash.

However, when you are closer to retirement, you need to reduce your investment in stocks and increase your investment in fixed-income securities.

Analyze your current portfolio, consider how close or far you are from retirement, and decide if you need some adjustments. You may need to increase your stock or fixed-income investments as the case may be.

Returns and Risk

Another issue to consider when evaluating your portfolio is the risk-return dynamics. The question is, “does this particular investment provide a higher return for a higher level of risk, or can I get the same returns (or comparable returns) for a lower level of risk?”

There is no point in taking a higher risk if the returns are not significantly better. Similarly, you need to consider if you can get a higher return at the same level of risk (or comparable level). An example of this is high-yield savings accounts. Some online banks will pay you a higher rate of interest without any stringent conditions. Why keep the savings account with your bank if there is another trustworthy bank offering higher returns with no difference in risk (except the online bank is not FDIC-insured).

You should do the same for your stocks and CDs. For stocks, you need to consider if other companies also meet your criteria but pay higher returns with no additional risk. Why not take advantage of those opportunities. For CDS, it may surprise you how many banks offer a higher return than the one you currently use (with no significant increase in risk). This is the art of shopping around. However, always keep your financial goals in sight.

Company Fundamentals

There is no true evaluation of investments that do not evaluate the fundamentals of the companies. This is especially applicable to stocks and corporate bonds. For stocks, you need to be sure there has not been a significant change in the fundamentals of the company that makes it fall short of your criteria.

Such fundamental changes may include a change in management or technological disruption in the industry. The value of a company is in its ability to earn consistent and stable returns over the long run. If you see non-temporary factors that cast doubt on this, you may need to sell your stake in that company. There are temporary changes that may cause a decline in performance. However, here, we are looking for more significant (fundamental) changes.

Funds

When you purchase mutual funds, the level of evaluation changes. Now, you are not evaluating individual stocks (since you don’t have a choice in the stocks the fund buys) but mutual funds. When you assess a fund, you are keeping an eye on their expenses ratio, management fees, and performance.

If other mutual funds publish better performance at an equal or lower cost (expenses ratio and management fees), you should consider jumping ship. Do not forget to use index funds to manage risks. Also, seek the right balance between equity and fixed-income funds.

Tax Efficiency

Does the structure of your portfolio provide tax advantages or disadvantages?

You may think tax does not matter, but it does. Including tax-free (at the level it is tax-free) federal and municipal bonds can be a good idea. If the interest from your corporate bonds post-tax is lesser than the interest on your federal and municipal bonds, why not take the tax advantages (and lower risk) of the latter.

Index funds tend to generate less tax expense than actively managed funds. Ask yourself if the advantages of purchasing actively managed funds outweigh the extra tax expense. You should also consider the tax benefits of ETFs and how they may fit into your portfolio.

Small-cap stocks tend to accumulate more tax expenses due to the frequency of purchase and sale. If you are an income investor, you need to keep the right balance of small-cap, mid-cap, and large-cap companies to achieve tax efficiency.

Inflation

An investment that does not beat inflation is hardly worth purchasing or keeping (ceteris paribus).

When you evaluate your portfolio, make sure your investments have returns that beat inflation. If they do not, it may be time to consider replacing them with investments that do.

Fees

Brokerage fees are part of the cost of investing in some classes of assets (stocks, especially). These fees may be insignificant until you look at them in a summary fashion. You must shop around for the most reputable brokerage firms with the lowest fees. The fee is not everything. However, after you have considered all the other essential factors, you will still find companies that meet those criteria and charge lower fees. Shop around for the best deals.

Ensure you are keeping your costs to the barest minimum.

Conclusion

He, who fails to plan, plans to fail. Also, he who does not evaluate his actions according to the plans is better off not planning. Evaluation (controlling) is the key to everything in life, including investments. Keep an eye on your investments and ensure your current portfolio is structured in a way that makes it easier for you to achieve your goals.

Investing in Certificates of Deposit (CDs)

March 24, 2020 by Paul Owolabi Leave a Comment

Introduction

In these series of articles (start here), we have been looking at different ways you can invest your money to grow it and achieve your financial goals.

Today, we look at certificates of deposits as one of those tried and tested investment channels you need to consider in your investment portfolio

What are Certificates of Deposit?

Certificates of Deposits are products offered by banks and credit unions whereby an investor deposits money and leaves it untouched for a predetermined period (term) in exchange for periodic interest payments.

Features of Certificates of Deposit

Fixed-deposit: CDS are fixed deposits, and the investor cannot withdraw the money before the maturity date without paying an early withdrawal penalty (ceteris paribus).
Fixed interest rate: The bank or credit union sets the interest rate on a CD for the term of the fixed deposit. The interest rate does not change with market dynamics. The interest rate accumulates either on a monthly or quarterly basis.
Maturity Date: Every CD has a term ranging from 6-months, one year, two years, and five years (generally). The maturity date is when the term ends, and the principal and interest accumulated during the term becomes payable.
Lump-sum payment: Generally, you can only make a single lump-sum payment to one CD account. You cannot top up your deposit during the term of the CD. If you need to invest more money, you have to open separate accounts.
Minimum Deposit: Every bank or credit union has a minimum deposit requirement.
Maturity: When a CD matures, you can either withdraw the money, roll it over to a new CD, or transfer it to a saving or checking account at the same bank.
Tax: Interest earned on CDs are taxable. The interest is taxed when the bank adds the interest to the balance on your account and not at withdrawal.
Withdrawal Penalty: Each bank and credit union has different policies regarding the early withdrawal penalty. Generally, the penalty is always in the form of interest payments for a specified period. For example, if you purchase a one-year CD and wish to withdraw before maturity, the penalty can be the forfeiture of a month to three months’ interest out of the interest accumulated until date. The interest you forfeit (number of months) will be higher for CDs with longer terms (up to 6 months for a three-year CD)
Safety: The FDIC (for banks) and NUCA (for credit unions) protect your deposit in a CD for up to $250,000 per account.

CDs vs. Savings Accounts vs. Money Market Accounts

How do CDS compare with Savings accounts?

While a savings account allows you to make six withdrawals per month, a CD is fixed for the term of the agreement. Generally, you cannot withdraw your money before the maturity date on the CD. Savings accounts are liquid, while CDS are not.

However, CDS pay a higher interest rate than savings accounts. The higher interest rate compensates for the illiquidity of the money.

Most savings accounts do not have a minimum deposit requirement, while CDs require minimum deposits.

CDS are also different from the money market deposit account due to their illiquidity. The latter also allows six withdrawals per month with some features of a checking account.

Direct CDs vs. Brokered CDS

You can buy CDs directly from banks and credit unions. Alternatively, you can buy them through your brokerage firms.

Brokered CDs pay lower rates, but they are easier and more convenient to set up and operate. Since you have an account with the brokerage firm, they can easily set up a CD without all the attendant paperwork. Upon maturity, they will also easily transfer the money to your cash account with the firm.

Factors affecting the interest rate on CDs

Two major factors affect the interest rate on CDs

Federal Funds Rate: There is a direct relationship between the federal funds rate and the interest rate on CDs. When the FFR is low, banks do not have an incentive to borrow from the public, which results in low interest rates. Conversely, when the FFR is high, banks will prefer to borrow from the public, which makes CDS more desirable. Consequently, the interest rate rises.
Demand-side: Banks lend money to give out loans to their customers. One way they lend money is through the CDs. Therefore, when a bank has a low demand for its loans, there will be less interest in issuing CDs (lower rates), vice versa.

Specialty CDs

While many of the features of CDs listed above apply in a wide range of cases, some specialty CDs offer more flexibility on one of those features.

No-penalty CDs

Some certificates of deposits overrule the early withdrawal penalty that is a standard feature of CD. The trade-off is in the interest rate. These no-penalty CDS will offer lower interest rates than the standard CD.

Add-on CDs

Add-on certificates of deposits offer flexibility with the lump sum, fixed-deposit feature of CDS. They allow you to make additional deposits during the term of the CD. These additional deposits also earn taxable income. All the deposits and interest earned are payable at maturity.

Bump-up CDs

A bump-up CD offers flexibility with the fixed interest rate feature of CDS. It gives you one opportunity to lock in a higher rate during the term of the CD. It means when the current interest rate exceeds the interest rate when you purchased the CD, you can lock in the current interest rate and override the initial rate. However, you can only do this once during the term of the CD.

Jumbo CDs

These CDs tend to have a higher minimum deposit requirement than others. Some Jumbo CDs can have a $25,000 minimum deposit requirement. Others can have a $50,000 minimum deposit requirement. These Jumbo CDs tend to pay a higher interest rate

IRA CDs

IRAs can also decide to invest in CDS. CDs specific to retirement accounts are called IRA CDs.

Callable CDS

These certificates of deposits give the issuer the legal right to recall the CDS at any time. Callable CDs do have a higher interest rate to compensate for the uncertainty they introduce. When the bank or credit union recalls a CD, it stops earning money, and thy return your principal and interest earned up to that point.

Pros of Certificates of Deposits

There are many advantages of certificates of deposits. Below are some of them:

Higher interest rates than savings and money market accounts:
Safe Investment: Your investment in a CD is backed the FDIC and NUCA (as applies) up to $250,000 per account
Certainty: When you invest in a CD, you know how much you expect to withdraw at the end of the term. The interest rate and duration are fixed.
Bolsters a saving culture: When you lock your money in a CD for a term without withdrawing (or withdrawing at a penalty), it helps to enhance your saving habit.

Cons of Certificates of Deposits

However, there are some downsides to CDs:

Low interest rate: When compared to stocks and bonds, CDs offer a low interest rate. The industry rate may not even beat the inflation rate
Early Withdrawal Penalty: Withdrawing money from a certificate of deposit before maturity attracts a penalty
Opportunity Cost: When you lock your money in a CD, you cannot take advantage of higher interests rate later on (except for bump-up CDs). Also, you can’t take advantage of better investment opportunities without a cost (except for no-penalty CDS that pay lower interest rates)

Should you buy Certificates of Deposit?

With these advantages and disadvantages, is it advisable to buy CDs?

Use CDs to hold part of your emergency funds: CDs are good investment channels for emergency funds. The illiquidity of CDs may make you wonder if it is suitable for emergency funds. However, it should be said that emergency funds should not be too liquid. If they are, you would probably empty the account before there is a real emergency. CDs will grow your emergency funds faster while offering you the opportunity only to withdraw when there’s a real emergency (for fear of penalty). You would only be willing to take the penalty for a real need.
Investment targets: There are times you save money to make some future purchases. You may want to save to buy a car, make a down payment on an apartment, go on vacation, etc. In these kinds of scenarios, investing in stocks or mutual funds won’t fit the bill. You will need a stable, safe, and secure investment where you cannot lose your money. In such instances, CDs are suitable investments.

Recommendations

Below are some suggestions for investing in certificates of deposits:

Use a CD ladder system (similar to the bond ladder system): The ladder system allows you to minimize the risk of locking down your money. You can purchase a CD that matures in different periods. For example, you can buy a six months CD, a one year CD, a three year CD, and a five year CD rather than investing all your money in a five year CD. In this way, you can take advantage of the future rise in interest rate.

Instead of investing $100,000 in a five year CD paying 5%, you can invest $20,000 in six months, one year, two years, three years, and five year CD. At the end of the first six months, you can then purchase a five-year CD at a higher rate (if the rate is higher). The same thing applies at the end of the one-year, two years, and three year CD. This is especially helpful if you look forward to higher interest rates.

Shop Around: CD rates vary across banks and credit unions. Some banks will pay three to four times more than the industry average. You must shop around to ensure you are getting the best value. The Balance has a website page where they update the top-paying CDs and their features.
Embrace Odd terms CDs: These are CDs with 17 months, 21 months, etc. Some of these odd terms, CDs pay more than the conventional CDs (6 months, one year, and two years, etc.) with no extra downside. If the oddness of the term is the only problem, by all means, embrace odd term CDs with better interest rates.
Be open to promotional offers but know all the details: Banks and credit unions do make promotional offers that pay higher interest rates. You should be open to such. However, you need to be sure of every single condition and feature.
Have a plan: Always focus on the end game. Do not buy CDs for the sake of it. Ensure you buy them because they have a place in your overall financial plans and goals.

Conclusion

Certificates of deposits are one of the investment channels that every investor should know about and explore. They are a good place to hold your emergency funds and money for some short-term and medium-term purchases.