RateLadder made a guest post on LazyMan’s blog on a strategy he is using to fund his Simplified Employee Pension Plan (SEP-IRA). A SEP-IRA is a retirement plan for individuals that are self-employed, and thus do not have an employer sponsored plan (such as a 401k or 403b). Basically, he is taking out a loan in order to fund his retirement plan. The thing that I really like about the idea is that the tax benefit will more than pay the interest on the loan (even though it is a 36-month loan)!

Of course, the best way to fund your retirement is to make regular contributions towards a retirement account, such as a Roth IRA or traditional IRA. For 2007, the contribution limit for an IRA is $4,000. If you made regular monthly contributions, that would be $333.33 per month (plus an additional $0.04 somewhere in there). Although it is now 2008, it is still possible to contribute towards the 2007 limit until April 15 (individual tax return deadline). If you would like to max out your 2007 contribution before the deadline, do not currently have the money to do so, and you are capable of contributing $800 or so over the next 12 months, you may want to consider a strategy similar to RateLadder’s.

If you are considering a similar strategy, I would recommend you take the loan for a year. That way your payments will approximate those for the annual contribution limits and you will pay less interest. Let’s do an example with a few assumptions (similar to RateLadder’s):

• Your current tax bracket is 25%
• You have at least $800 in discretionary income to contribute towards retirement
• You are funding a traditional IRA (although a Roth IRA is better for the long term, it does not have the immediate tax advantage that will be discussed below)
• A $4,000 loan will be taken to fund the retirement account
• The interest rate on the loan is 10%
• You will be making the 2007 maximum contribution of $4,000 with the proceeds of your loan
• The loan will be paid within 1 year

The monthly payments on a $4,000 loan that will be paid in 12 months will be $351.66. The total interest paid will be $219.96. The tax benefit from the traditional IRA will be $1,000. The net benefit from the strategy will be $760.04. If the monthly payments are only $351.66, why did I say you needed at least $800 in discretionary income to contribute towards retirement?

The strategy really only makes sense if you intend to max out your IRA contributions every year. So that means you will need to contribute an additional $416.66 per month if you are to max out the 2008 contribution limit of $5,000. Otherwise, you would have to take out another loan next year to max out the 2008 contribution, and you would be playing catch up each and every year. If you’re going to be taking out a loan every year, you may as well just start making regular contributions now until retirement instead of using the strategy I’ve described.

If you or your spouse already contribute towards an employer-sponsored plan (401k or 403b), there are limits to the amount that can be deducted on contributions made to a traditional IRA depending on your adjusted gross income (AGI). This will limit the amount of tax benefit for your contribution, but you can still contribute the maximum annual amount of $4,000. You can refer to IRS publication 590 for more information. The strategy could also be used to max out a Roth IRA, but you will not have the tax deduction benefit to help cover the interest expense of the loan.

Prosper.com is definitely a good place to get a loan. Although Prosper loans are 36-month loans, it is easy enough to make over-payments to pay the loan within 12 months. You could also use a home equity loan to fund the retirement account, and take advantage of the deductible interest as well! Whatever strategy you use to fund your retirement, it is important that you do it as soon as possible. The more time your money has to grow, the more comfortable your retirement will be.

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On Tuesday the Federal Open Market Committee (FOMC) dropped the federal funds rate by 0.75% in an emergency meeting. What does this mean for mortgages? The federal funds rate does not actually directly impact fixed mortgages. Because fixed-rate mortgages are long term loans, they tend to more closely follow long-term paper such as the 10-year treasury note and 30-year treasury bond. The 10-year treasury note and 30-year treasury bond have been on a steady decline since July, as have 30-year and 15-year fixed mortgage rates.

Treasury yields have dropped quite a bit in the past two days since the FOMC announcement which is good news for anyone looking to buy a home. The yields aren’t dropping so much as a direct result of the federal funds rate drop, but more because of the message the FOMC has sent as a result of the action they have taken. I read a good article this morning that describes the situation well:

Mortgage rates often dip when investors fearing an economic slowdown grow more conservative and buy up Treasuries and bonds. This causes long-term rates — and by extension, mortgage rates — to fall, creating an opportunity to get better terms on a loan.

Although normally this would be good news for borrowers with adjustable rate mortgages that wish to lock into long-term fixed-rate mortgages, they may still find themselves unable to refinance. During the housing boom many people used adjustable rate mortgages with small down payments to purchase their homes. They did this in anticipation that home prices would continue to climb, and the market value would allow them to build equity in the home. Unfortunately when the real estate market topped out, these individuals were left with very little home equity or even worse, negative equity in their homes.

With little or no equity in a home, it will be very difficult to refinance into a fixed-rate mortgage. Without at least 20% equity in a home, a homeowner will have to pay Private Mortgage Insurance (PMI). This helps lenders to recover losses from defaults and provides no benefit to the borrower. I have no doubt that PMI premiums have increased ever since the subprime lending issues began. This means a higher monthly payment which may not make it worth refinancing since it could possibly push a homeowner into negative cash flow. On top of having higher payments with PMI, payments on a fixed-rate mortgage will include principal as well as interest. Once again, the higher payment could force a negative cash flow situation. Even given all that, with lenders tightening borrower requirements, it may only be possible for those with excellent credit to refinance if they have very little or no home equity.

So what is a homeowner with an adjustable rate mortgage and very little equity to do? Well, one good thing about the reduction in the federal funds rate is that it could possibly lower the monthly interest payments. This would allow a homeowner with an adjustable rate to increase the amount of principal paid, hence build some equity. Hopefully the decrease in short-term rates will help homeowners with adjustable rates to build sufficient equity and allow them to refinance before fixed-rate mortgage rates begin to increase once more.

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What does it mean to invest? Investing is the process of providing capital for the receipt of future income, appreciation in the capital, or both. In providing the capital, the investor assumes some risk: the possibility of losing some or all of the invested sum. Typically speaking, when there is higher possibility of loss there also needs to be greater gains in terms of capital appreciation and income in order to offset the risk. The best investors are those that are able to best understand and manage risk, as well as analyze and understand the potential of future income.

Warren Buffett is no doubt one of the best investors of all time. Not only is he an excellent judge of risk and profits, but he has the uncanny ability to properly assess the value of an investment. Even if a company experiences excellent growth and profits, if it is overvalued there is some risk that eventually the valuation of the company may drop to a more reasonable level. Buffett will only invest in a company if he believes it to be fairly valued, or even better undervalued.

So how do you determine the value of a company? There are many methods, but fundamentally speaking I like using discounted cash flows (DCF). With DCF, you discount estimated future earnings by the sum of the risk-free rate (federal government bonds) and a risk premium. The Business Plan Store has a good example here. Robert G. Hagstrom wrote an excellent book called The Warren Buffett Way, in which he provides some insight into how Buffett performs some DCF analysis to value business he has invested in. Later this week, I’ll provide you with an overview of Hagstrom’s calculations along with some examples.

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I remember ages ago when Google Fight went viral (even before the term viral went viral). Just for grins, I performed a Google Fight between Prosper.com and LendingClub.com:

Prosper wins by a score of 135,000 to 13,700!!!

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If you are a recent college graduate that has just entered the workforce, you have an excellent chance for a comfortable retirement if you begin contributing to your retirement as soon as possible. If you are 24 years of age or younger, you have at least 35 years until you reach age 59 1/2 (minimum age to begin withdrawing from a retirement account without penalty). That’s at least 35 years to let the magic of compound interest work for you. What exactly does that mean? Let’s look at some numbers as an example with a few basic assumptions:

• There are 35 years between now and your retirement
• Your retirement investments average a 10% annual return (fairly reasonable long-term return estimate)
• Inflation over the next 35 years is 4%
• You invest $50 a paycheck and you are paid biweekly (26 paychecks a year)

By investing just $50 every two weeks at a 10% annual return, in 35 years you will have $414,620.36! However, accounting for inflation, it would only be worth $154,839.47 in today’s dollars. That’s not bad pile of cash, but it won’t be enough to get you through retirement. That means you’re going to need more than just $50 a paycheck. If your employer has a 401k plan in which they provide matching contributions, it can help be a source of the extra money you will need.

A 401k is an employer-sponsored plan, where employees can make pre-tax contributions into a retirement account. The contributions made in the account grow tax-deferred, meaning they are not taxed until withdrawn during retirement. More often than not, as an added benefit employers will contribute matching funds for employee contributions. For example, my employer will match 100% of the first 3% of salary contributed, and 50% of the next 2% of my salary. Confused? Basically, it means if I contribute 5% of my salary my employer will match with 4% of my salary.

Let’s continue the example with the 4% match on 5% of salary. To keep things simple, let’s say that $50 biweekly is 5% of your salary and is your contribution in your 401k. That means for every $50 you put in, your employer will contribute $40 more. With $90 in biweekly contributions, in 35 years you will have $746,316.65 or $278,711.04 in today’s dollars. Of course, if you as me, you should try to contribute more than just 5% of your salary.

So what’s the catch with the employer matching? In order to become fully vested (be allowed to keep the match), you have to remain an employee with the company for a specified amount of time. Your employer may allow you to keep all or nothing after a certain period of tenure (cliff-vesting schedule) or they may allow you to keep certain percentages after reaching certain tenure milestones (graded-vesting schedule). Regardless of your tenure, if you leave the company all of your contributions will remain yours.

If your employer doesn’t have a 401k plan, there are other types of retirement accounts you can open on your own behalf. One of the best is a Roth IRA (Individual Retirement Account). With a Roth IRA, you make after-tax contributions into a retirement account that grows tax-free. That means when you withdraw during retirement, you won’t pay taxes on it. There are some income limitations, so if your income is too high (six-figure range) you won’t be able to contribute to a Roth IRA, but you can still contribute to a traditional IRA. With a traditional IRA, your contributions grow tax-deferred. That means you will have to pay taxes when you begin making withdrawals during retirement. So you can see, the Roth IRA is more advantageous if you qualify for it. There are annual contribution limits for both types of accounts.

When you first begin contributing to a retirement account, if you are young and a long way away from retirement, you should put your money into aggressive growth investments. The value of the account may move up and down considerably with aggressive investments, but in the long run it should increase. As you near retirement, investments should become less aggressive in order to preserve the earnings made over the years. That means that it may be possible you may not even reach the $278,711.04 in today’s dollars mentioned in the example. However, there is some good news that will help you accumulate more wealth for retirement. As you continue working, your salary should increase as you receive merit increases, cost of living increases, and advance into positions with a higher salary. This means that your contributions will not remain constant, but should gradually increase year-after-year.

How much money you will need for retirement depends on your life expectancy, how much you will need to withdraw each year, and what kind of return you are receiving while you are withdrawing. Maybe $1,000,000 sounds like a good number. Let’s see… Here are the assumptions:

• You have accumulated $1,000,000 for retirement
• You withdraw $70,000 per year
• During your retirement, your $1,000,000 is earning 3% interest
• During your retirement, inflation is growing at 4%, giving you effectively -1% interest

$1,000,000 would last you about 14 years. If you start withdrawing at age 59 1/2, that means it would last you until age 73. Hmm, that’s probably not long enough. But wait, it gets worse! Although we did account for inflation during the retirement period, we forgot to adjust the $70,000 annual withdrawal for inflation. The equivalent of $70,000 in todays dollars will be nearly $300,000 in 35 years (with 4% inflation)! If you want to withdraw $300,000, your nest egg is only going to last you about three years. Yikes!

If you need $300,000 year for 30 years in retirement, that means you will need to accumulate over $10 million! Although that may seem like an impossible task, it can be accomplished. The earlier you start, the better your chances of achieving a comfortable retirement. It gives you more time for compound interest and your increasing salary to work for you. The more you contribute each paycheck, the better your chances are as well. So what are you waiting for?!?

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