Real Estate: A Solid Option for Added Income

What are our best alternatives for additional retirement savings? We considered contributing to a Roth IRA but aren't sure what the consequences would be at the end of the year if we earn too much to be eligible. Most commentary seems to focus on people trying to "catch up" or higher-income families that have already sorted these issues out. But I have to believe there are a lot of us borderline folks earning near the limits that could really use the education to help us jump to that next level. Thanks!

Tim and Debbie

Well, this is a good problem to have. You may or may not be able to contribute to a Roth IRA. Eligibility is based on modified adjusted gross income (AGI), so even if you're at the top end of the phase-out range ($160,000 for married filing jointly, $110,000 for single), you may be able to lower modified AGI by the amount you contribute to your 401(k)s. If you go ahead and contribute, and later find out you are ineligible, you can recharacterize those contributions to a traditional IRA (although you wouldn't get a deduction for them).

In addition, there are two possibilities for additional investments that come to mind. First, save in taxable accounts. Second, consider purchasing additional real estate properties. When I design portfolios, I like to see a balance among taxable accounts, net equity in real estate, and retirement accounts. It sounds like your retirement accounts are probably a much bigger piece of your net worth than the other two areas.

Saving in taxable accounts helps you diversify your tax risk. No one knows what will happen with tax rates in the future. There's even talk about President Bush moving toward a consumption tax. Just like you would diversify the holdings in your portfolio, you should think about diversifying the types of investment vehicles you hold to hedge future tax scenarios.

When investing in taxable accounts, you'll be able to take advantage of lower capital-gains rates when you sell stocks. And if you've had a loss on an investment, you can use it to your advantage by netting out capital gains.

Purchasing real estate properties can also be a good way of rounding out your portfolio holdings. Many investors find they enjoy owning a property in an area that they can visit periodically. When they aren't there, they can rent the property and use that money to offset any debt and other related expenses.

Because real estate can be more illiquid than other types of investment assets, be careful when you are choosing potential properties. Most important will be location, of course. You may also want to think about demographic trends too. As baby boomers get older, they will probably be looking for retirement homes (or second homes). Think smaller, efficient, maintenance-free types of living.

Dear Ms. Stevens:

I am supposed to invest $145,000 of my parents' retirement funds, which are in the names of my brother and me. We will need to have $45,000 available for use within six months to add a garage apartment onto our home for them. I am in a quandary about what to do with this.

I thought about putting it into mutual funds (bonds and stocks, more heavily in bonds). I also talked to a CFP through our bank. I have waffled back and forth on whether or not to do this through him and the bank. My husband thinks I shouldn't be paying a sales fee since I could do this through a no-load fund of some type. After much thought (two months' worth), I decided that I absolutely have to get some other opinions on this.

One CFA told me that I was not sophisticated and educated enough of a client to be handled by him--we didn't fit his profile. This stung a bit, but I have recovered. Can you give me any words of wisdom with this problem? I don't want to do anything that would cause them to lose their retirement funds, and I would like to add to their funds, as well. Thanks.

Pat

P.S. My father is 84 and my mother is 78. I am 53.

You need to be very careful with this money. If this is all your folks have for retirement, it needs to be invested prudently and wisely. There's not enough information here to be able to comment much on how to plan for their retirement years, but I can comment on what to do with the money that's needed in six months.

When you need to tap money in a short period--let's say 18 months or less--you really can't risk it in a stock or bond fund (except perhaps a very short-term bond fund). You need a good money market account that pays a decent amount of interest. What comes to mind in your case is that if you can round up that $45,000 to $50,000 you can qualify to meet the minimum in the Vanguard Admiral Treasury Money Market account. The expenses are rock bottom at 0.13% and it's currently yielding 2.21%. You can read more about this fund here. Although the minimum to open the account is $50,000, you can withdraw money after that and hold a lower balance. If you withdrew the $45,000, you'd still have $5,000 in a great money market account.

Dear Sue:

My wife and I are in our early 60's (62 and 63) and both in good health with family histories that suggest we stand a good chance of living into our late 80s or early 90s. My wife has already retired and when I retire in 18 months, between the two of us we will have lifetime government pensions totaling $65,000 per year in the year of my retirement with a guaranteed annual 3% increase in the pension income. When we both qualify for Social Security, our combined Social Security income will be approximately $35,000 per year. We presently have savings of $750,000, of which approximately $500,000 is invested in stocks and approximately $150,000 is invested in cash or cash equivalents, and approximately $100,000 is invested in municipal bonds. We expect to receive inheritances within the next five to 10 years of at least $350,000, and perhaps as much as $500,000. Our only debt is a home mortgage with about $50,000 remaining to be paid on a house and property with a fair market value of at least $300,000.

In view of the income stream we will be receiving from state government pensions and Social Security, I am inclined to the view that even during our retirement years it would be reasonable to invest a large portion (70% or 75%) of our savings in stocks, but I am frustrated by the fact that my own stock-picking has produced such unpredictable and unrewarding results over the past eight or 10 years. For several reasons, I am reluctant to put all of my assets in the hands of an investment manager and let the manager make all of the decisions. It also appears to me that even the great investment managers rarely produce results year after year that beat the market averages. All of which leads me to my question.

Would it be a reasonable choice for someone with my circumstances to quit trying to pick individual stocks and instead limit my equity investments to index funds and/or exchange-traded index investments?

Michael

YES. You are in a very fortunate situation with your inflation-indexed pensions. You can afford to take on more risk with your portfolio than others with less steady income streams. By all means consider indexing for the "core" of your nest egg. Chances are you'll probably achieve more consistent results (and in retirement, consistency counts for a lot), lower your expenses, and worry a lot less.

If you still want to own a few stocks or a few actively managed funds, you can always take a core-and-satellite approach. This strategy involves putting the majority of your money in very tax-efficient types of investments (the core), such as index funds, exchange-traded funds (ETFs), or even tax-managed funds. Then around that you build satellites that can take on more risk by taking a more active position. That could be focused mutual funds that only invest in a limited number of stocks. That might mean holding a few individual stocks that you are particularly interested in. Or it might mean holding actively managed funds in less efficient areas of the stock market, such as smaller-cap stocks or international stocks.

You don't have to hire an investment manager to execute this strategy. You can do it all at Vanguard or another brokerage house like T.D. Waterhouse or Fidelity. Of course, you can also find reputable investment advisors who will help you set up this type of portfolio.