Expert: Gina Boykin - 5/24/2008

Question
QUESTION: I'm a 30 year old graduate student who's beginning to think about retirement. I'll try to sketch out my current financial situation and then ask for your advice on the future.

My father recently left me $50,000 when he passed away. I immediately paid off $20,000 in student loans, and struggled with what to do with the rest of about $10,000 in debts that I'd accrued over the past 5 years and hadn't been able to consistently pay on. These debts are varied-- a lot of small amounts from cell phone bills to medical bills to vet bills to blockbuster fines I never paid.

I met with a rep at a community nonprofit that helps with budgeting and spending. He told me that since these are all such "old debts," that I make so little money, and have no real assets (like owning a house), that there's little chance the companies would ever realistically sue me for the amounts. He couldn't advise me to ignore the debts, but basically all but said "hang out for 7 years and they will 'fall off' your credit report."

I guess I'd first like to ask you about the advantages of paying off those old debts vs. investing my retirement (and if it's the latter, how to do that).

After I paid off the student loans, my mom insisted I meet with an old friend of my dad's, who is a investment consultant at Wachovia. He put the remaining $30,000 into a variety of regular mutual funds, which I now receive statements on.

My ultimate goal is to responsibly save for retirement. Should I instead have this $30,000 in some sort of IRA? I understand that this could give me tax advantages, but am fuzzy on what those are exactly.

I think I understand that a regular portfolio of mutual funds just necessitates that, as far as taxes are concerned, you "pay as you go," whereas an IRA is tax-deferred. I make less than $20,000 a year now as a grad student and will for at least 5-6 more years. Does it not make sense to pay now as I go (e.g. keep the money in mutual funds) since tax rates for capital gains, are based on my (low) income? I hope to be a professor by the time I'm 59.5, with a higher income, when I pull all the money out of an IRA.

So-- keep the money in the regular mutual funds or put it in an IRA?

I'm not sure any of this reasoning is sound, but would very much appreciate your help!

A very confused,

Erin

ANSWER: If you do want to invest for retirement, you can do that and have an IRA at the same time - it's called the Roth IRA.  You can only invest $5,000 in 2008 in a Roth IRA, but here's the great thing - all of the gains are TAX FREE, NOT tax deferred.

The other great things about the Roth IRA is that you can take your contributions out (just leave the gains in) anytime after the account has been opened for five years, without penalty.  (There's penalties for taking money out of a traditional IRA).  So if you decide to use some of the money toward a downpayment on a home later, you can do so.

I would suggest that FIRST you educate yourself. Don't hand your money over to ANYONE without understanding what they are doing with your money.  It disturbs me think that you gave your money to a bank consultant to invest in something that you don't understand.  The mutual funds he invested YOUR money in - do you know anything about the fees?  Are these "no load" or "loaded" mutual funds?  A load is a fee.  It can be charged when you buy the fund (front-end load) or when you sell it (back-end load).  The problem with loads is that no-load funds have historically done just as well.  The other problem is that the bank consultant may be suggesting funds with certain fees because he gets a commission for doing so.  Find out as soon as possible if your funds are no-load.  Also, if your consultant suggests that you sell funds and purchase some different ones, make sure that the new ones don't have fees.  Sometimes people will ask you to keep trading, which is also a way for them to make money.

I don't mean to scare you, but I do want you to understand the importance of educating yourself.  Never take anyone else's word for granted.

Please check out websites such as investopedia.com, youngmoney.com, or fool.com so you can understand some basic investing terms.

So, back to retirement.  You can transfer $5K each year into a Roth IRA.  Once it's moved to the Roth, you won't have to worry about "paying as you go".  You can open a Roth with any of the major brokers (Vanguard, Fidelity, Etrade, etc) or you should be able to do the Roth with your bank consultant.

When get full-time employment, your employer may also offer a 401(k), which is another way you can save over time, little by little, for retirement.

Since retirement is not your only goal, some of the money can also be in a savings account for emergencies and short-term goals.  Mutual funds are no place for these things. You need the ability to access the funds without penalty.

With regards to your debts, morally, if you have the money you should just go ahead and pay them.  If you care about your credit report and credit score, it will look better for you to settle with your debtors and pay them off (they will most likely accept far less than the total amount you owe) than to have complete chargeoffs.


---------- FOLLOW-UP ----------

QUESTION: Hi Gina,

I've asked at least 10 people this question (several in person) and your answer was, by far, the most comprehensive and complete. Thank you so much for spending so much time answering.

Quick follow-up question: I should ask my investment consultant at Wachovia ASAP if the mutual funds are "load" or "no-load," (If they are "no-load," how does he make any money?) as well as an explanation of the funds' fee structure. Is that basically it?

Then you would recommend going to Fidelity, Vanguard, etc., or simply sticking with him (Wachovia) to open the Roth IRA?

Again: many, many thanks. I'll pass on what I have learned to other women.
Erin

Answer
Mutual funds usually have one or more of the following fees: loads (a fee for buying or selling the fund), management fees (a percentage that is paid out of the fund for the mutual fund manager), 12b-1 fees (this is similar to a load - stay away!) and short-term trading fees (a fee that discourages frequent trading. for example, a fund may have a fee to sell shares that you've owned less than a year).  These are the main ones, but there could be others.

All funds have management fees.  If you go to one of the discount broker  websites and do a search for no-load funds, you will see the historical rate of return for 1-yr, 3-yr, 5-yr, and/or 10-yr periods.  You will also see a management fee percentage.  You want low management fees because this ultimately reduces your return.  For example, if your fund earns 12 percent, but there is a 2 percent management fee, you will really only gain 10 percent.  As you can see, lower fees are better.  However, let's say you have another fund that historically earns 14 percent but has a 2.5 percent fee.  The fee is higher, but the net percent (11.5 percent) is also higher.  So fees aren't the only thing to look at, but they do matter.

If your funds are no-load, then your consultant is either charging you a transaction fee (which means the fund doesn't charge a fee, but he is) or a separate management fee that is a percentage of your account balance (look at your statements), or he could be paid directly by the companies that have the funds you are invested in. For example, if he is suggesting you invest in the Oppenheimer Strategic Income fund, Oppenheimer may pay him for suggesting this fund.

All of the discount broker websites allow you to select a fund and see ALL of the fees.  The consultant you are working with should be able to do the same.  The consultant can show you the "prospectus" which is a document that shows you exactly what the fund is invested in (i.e. energy stocks, bonds, real estate, foreign companies' stocks), what the fund's goals are (i.e. some funds focus on providing income, some focus on growth, some maintain capital), what  risks are associated with investing in this fund, and the fees.  He should be able to sit down and read over this prospectus and explain the details.

Whether you do the Roth with him or through a discount broker would depend on the fees. If he's going to charge you to make trades within a Roth, it's probably not worth it.