Expounding on Compounding

Dear Gail —

My husband is retired, collecting a company pension and his Social Security. I am still working and now contributing the max to my 401k plan. Because I took a new job in the middle of last year with a substantial increase, we find that we will owe the IRS money in April.

Can my husband still open a Roth IRA for $2,000 and is this a legitimate deduction that can help reduce our 2000 tax bill? 

Thanks for your help, 
Carlos L. Margo 

Dear Carlos,

Congratulations on finding a way to have others finance your home! For those of us for whom a single family home is NOT an absolute "must," a multi-family dwelling such as your fourplex makes a lot of sense.

Here are some things to consider: Before you commit to either paying off the mortgage at a faster pace or increasing your contribution to your retirement plan, you ought to establish an "emergency" fund. The fact that you are a landlord dependent upon three rents coming in every month makes this even more important. Add up your fixed monthly costs (car payment, insurance, utilities, food, etc.) and multiply this by six. Then throw in three months of rent on one apartment. This money should be set aside in a liquid account such as a savings account or money market fund.

This type of emergency fund should be every consumer's first line of defense against unforeseen expenses. Once it is established, you should be able to breathe easy knowing that even if one unit is vacant for as long as three months, you have the money to make up the difference.

Next, what interest rate are you paying on your mortgage? From a strictly mathematical viewpoint, if you can invest your money someplace else and get a higher return, then that is what you ought to do. However, as I've noted in previous columns, there is a psychological payback when you reduce the outstanding mortgage on your home. For a lot of people, this brings tremendous peace of mind. Only you can put a value on that.

Personally, if I were your age I'd dump as much as I could afford into building up my retirement nest egg. As I wrote two weeks ago, time can have a bigger impact on your results than the investments you choose. While there can be no guarantees, thanks to the magic of compounding, "Time" really can translate into "Money." The more time available for your money to grow, the fewer dollars you have to invest to reach a specific goal.

Normally, I'd suggest maxing out your contribution to your retirement plan at work to take full advantage of any matching dollars your employer will contribute and then investing in an IRA.

But your college doesn't match your contributions — so I'm suggesting the opposite. You earn too much to make a tax-deductible contribution to a traditional IRA, so go with a Roth IRA. In your case, I especially like a Roth because of: 1. your age, and 2. the fact that money in a Roth IRA (unlike a traditional IRA or qualified plan) grows tax-free. And while you can't take out a loan from an IRA, there are other situations that allow you to tap your IRA account prior to age 59 and a half without incurring an early withdrawal penalty. So a Roth offers access to your money — albeit somewhat limited — plus tax-free growth.

Let's assume you figure you can afford to save an additional $250 per month, for a total of $3,000 more per year. Every month I'd put $166 into a Roth IRA and invest it in a growth-oriented mutual fund. Over the course of 12 months that works out to $1,992; throw in another eight bucks by April 15, 2002, and this year's IRA contribution is taken care of.

At the same time, I'd increase my contribution to the college retirement plan by $84 per month. Contributions to this account reduce your taxable income. Based on the rough numbers you've given me, you are either in the 28 percent or 31 percent tax bracket. So every dollar you invest in your Teacher Retirement System account shaves either 28 cents or 31 cents off your income tax. Look at it another way: The government is essentially subsidizing your retirement by not taxing you on the money you contribute.

When and if you get ready to move into a home entirely your own, I strongly suggest you seek the advice of a tax professional who can help you navigate the regulations and minimize the tax implications.

You're off to a great start! 

Hello, Gail
What are some investments that yield a compound interest on $$ invested.

Carol Davis 

Dear Carol,

"Compounding" simply means that the money an investment earns is added to its original cost so that future earnings are based on the total of the principal plus the income from the previous period. An investment generates income in different ways: Bank accounts and bonds earn interest, which is a fee the bond pays you for the use of your money; many stocks pay dividends, which are a share of the corporation's profits. As long as you are plowing the earnings back into your investment you are compounding its return. This would include, for instance, allowing the interest on a bank savings account to stay in the account instead of taking it as a withdrawal or using dividends earned by your stocks to buy additional shares.

This is one advantage of mutual funds: They make compounding easy and automatic if this is your wish. Mutual funds consist of a pool of money from thousands of investors. They can invest in everything from Treasury bills to stocks to natural resources to bonds to real estate. The manager of the mutual fund decides what specific securities to buy based on the fund's prospectus, the legal document which spells out how the money can be invested. As a shareholder in a mutual fund, you own a cross-section of all the securities the fund owns. When the mutual fund has earnings, instead of taking them in cash, you can instruct the manager to use them to purchase additional shares of the fund in your name.

But compounding is only as effective as the underlying investment. If there are no earnings, then there can be no compounding. If you sell too quickly because an investment exhibits more price fluctuation than you're comfortable with, this to negates the effect of compounding. Frankly, based on your question, I urge you to work with a professional advisor who can get you started on the right path.

Best wishes, 

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If you have a question for Gail Buckner and the Your $ Matters column, send them to moneymatters@newsdigital.com along with your name and phone number

The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.