My 401(k) Mutual Funds; Upcoming Interest Rate Cut

Since the stock market is taking a dive for the most part, I'm still paying more attention to the mutual funds.

I've finally went through the 401(k) mutual funds offered by my employer and will be posting my findings in a 6-part series. I'm breaking up 18 funds into 6 three-fund postings to make it more readable. Some reviews are more in-depth than others, depending on how much information was available for a particular fund. This is especially the case for the funds that are new. I have no idea why a 401(k) administrator would pick funds with virtually no history to speak of, it just doesn't make any sense to me. Of course I can of think of reasons for such picks, but none that would benefit the plan participants. In any case, that is what's coming up, along with my final choices (which are a bit unusual, but I had my reasons - you'll see!).

Also, now that I'm done with the 401(k) mutual funds, I will be going through the entire mutual fund universe to find funds for a non-tax-advantaged account.

While I'm here I might as well share my thoughts on the interest rate environment. There has been talk of Fed cutting interest rates before the next meeting as well as during that meeting (some people expect a total interest rate cut of 1%??). I don't think the situation is that dire and if the Fed will make a move before the next meeting it will send a strong signal that the economy is very weak and will do more harm than good as such a signal will support panicky investors' outlook. What I believe is the most likely scenario is that there will be a 50bps (0.5%) interest rate cut made at the January 30th Fed meeting. This cut is already highly expected by the markets so there should be no sudden spikes.

On a side note, Firstrade just e-mailed me that it will send me a free t-shirt! I've signed up with them back in December, but so far has made no trades because of the unfavorable market conditions. I wonder if they'll be sending gifts on a monthly basis, wouldn't that be nice?

Market Down; Stock Picks Looking Better; Mutual Funds for 401(k)

With the stock market going down (especially today after the employment numbers were reported!) my stock picks keep looking better and better. Overall they're down 9%, ranging from 4.8% price increase in Medtronic to a 16.7% price decrease in Cisco. When I say "down," I mean down since I've analyzed them since that is how they're being tracked in my spreadsheet. This basically means that it was a good call not to invest in my stock picks just yet (except for Medtronic, which is actually up).

So, for now I'm holding out on investing in the stock market. This "strategy" can be called market timing, but in my opinion it may be wised to wait a bit to see how everything will get sorted out since bad news keep coming out and a number of stocks on my "final" list are dependant on the overall economy since Coach and Harley-Davidson are in the "Consumer Discretionary" category, while Bank of America is obviously in the "Financials." Of course, there is a reward for taking a risk in the turbulent times, but at this time it's not clear whether the reward is great enough to compensate for the risk. In a way, that's what investing is all about: balancing risks and rewards to maximize the rewards with minimal risks.

Jumping to a different topic. I will be looking at mutual funds (and maybe ETFs), as the time will allow, while stock market is figuring itself out. Most of the mutual funds (although not all!) have already made capital gains distributions, so it's a good time to start investing in them. Also, I will need to pick mutual funds for my new 401(k) plan, which will involve looking over 20+ mutual funds. One thing I'm not clear about is whether load/no-load mutual fund structure matters in 401(k) plans since the benefit administrator has some sort of a pricing structure worked out with the employer. I'm wondering if and whether this differs from employer to employer and how those "load" fees are passed to plan participants. This may make a significant difference in how I choose mutual funds for the 401(k) plan. Any thoughts on this?

Exercising Stock Opions: When Should You Do It?

In the most recent issue of CFO (September 2007), one reader made a very good point about exercising of stock options. Apparently, people often assume that if they hold company's shares for a year after exercising the options, they'll qualify for 15% long-term capital gains rate. Even though a portion of that statement is correct, it is misleading nevertheless. Here is what that CFO reader had to say in the response to magazine's article about stock options:

"When one exercises an non-qualified stock option (NSO), he is taxed on the spread between the option price and the market value of the shares at the date of exercise. He pays income tax at ordinary rates on this spread whether he sells the shares or holds them. This is considered compensation and is also subject to payroll taxes. Future appreciation istaxed at capital gain rates (generally 15%) if the shares are held for more than one year from date of exercise.

"This incorrect tax perspective is frequently offered in conjunction with advice to exercise options at vesting and hold the shares until expiration rather than holding the options until expiration. While this approach will cause a portion of the profits to be taxed as capital gains instead of ordinary income, it requires a cash infusion at the time of exercise. Rather than paying the taxman at vesting, this cash could be invested in shares, which when appreciated, by any amount small or large, will more than cover the difference in taxes."

Now, if you're as "knowledgeable" about stock options as I am, you might wonder what is the difference between the "non-qualified" and "qualified" stock options. Well, as it turns out, there is no such thing as "qualified" stock options, they are called "incentive" stock options (ISOs). So, here are their respective Investopedia definitions to clarify this matter:

Non-Qualified Stock Option (NSO):

• A type of employee stock option where you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
• NSOs are simpler and more common than incentive stock options (ISOs).
  
• They're called non-qualified stock options because they don't meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.
  

Incentive Stock Option (ISO):

• A type of employee stock option with a tax benefit, when you exercise, of not having to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.
  
• Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.
• Also, numerous requirements must be met in order to qualify as an ISO.

Additional resources:

• Original CFO article ("Lessons in Sitting Pretty") this reader responded to: click here
  
• Full version of the reader's response ("Incorrect Tax Perspective") that I've quoted in this post: click here
  
• IRS explanation of the tax-treatment you can expect when you exercise your stock options: click here
  
• SmartMoney's take on this in "Options: Should I Exercise?": click here
  
• CNNMoney.com - Money101: Employee Stock Options: click here
  

Cashing Out Into An Early Retirement

Just finished reading the SmartMoney article on how a handful of couples have successfully retired early and found a balance and control of their lives. For some, who had seven-figure incomes, it was easier than for others, but even those with more modest middle-class incomes have managed to retire in their 40s and 50s. I would certainly like to do that as well. Of course, I always imagined myself not worrying about retirement since I will be a multimillionaire for some reason by then. But then again, it never hurts to have a backup plan.

So, here are some of the highlights:

• Set a goal and make a plan for your future
• If you want to retire in, say, your 40s instead of 50s, then save more rigorously and let stock market pick up the slack
• Find a source of additional income to either supplement your paycheck so you can save more money now and/or to supplement your retirement money once you do retire
  
• Live in the area with a lower cost of living if you can help it. You can save between 10% and 30% a year in living expenses by doing that.
• Make good investment choices with your set-aside money, don't let it sit in CDs or saving accounts. Stock market may be volatile, but over long term it delivers significantly higher returns than CDs, saving accounts, or bonds.
• Make a plan! If you want to retire 10, 20, or 30 years earlier, you have to plan for it, it will not just happen by itself!

Bonds or CDs?

Those looking to invest their savings into something other than, well, savings accounts, probably encounter bonds being mentioned as the more stable and safe alternative to stocks. But I think CDs should be the main competitor for bonds, not stocks.

Bonds' annual returns vary from 3% to 6% and their risks vary from Treasury-backed to junk bonds. So even though they're arguable safer than stocks, there is still risk involved and you'd have to dig into bonds or mutual funds invested in bonds and do some research before investing. Or, you could just invest into a CD for the time period from 1-month to 5-years with an annual return hovering around 5%. Oh yeah, and all CDs under $100,000 are backed by FDIC.

So, why bother with all the bond-related hassle when you can just put your money into a CD (or even several of them, for different time periods) and get virtually the same return with zero risk involved?

To invest in CDs or bank stocks?

Let's say you have some money sitting in your savings account and the current rate is barely keeping up with the inflation, where should you put it? The safest and most liquidate bet would be to put the money into CDs for up to 5 years. You can get your money back for a relatively low penalty anytime before the CD expires and your principal is backed by the government since all CDs under $100,000 are guaranteed by FDIC.

Or, you can invest into one of the bank's stock and 1) Receive a dividend that is likely to have a higher yield than a CD, plus bank dividends have a good chance of growing while CD rates are fixed; 2) Receive a lower tax bill since dividends are taxed at a preferred rate of 15% instead of the CD's interest being taxed at the ordinary rate of up to 35%; 3) By carefully choosing the bank to invest in, your total return would be even higher with a growing stock price for that bank.

Of course there are a few caveats that come with investing into a stock. It is not as liquid as a CD, it may decrease in value, and dividends can be suspended. Well, dividends are very unlikely to be suspended by a large bank that has a history of paying dividends for decades. Currently, many bank stocks are considered a bargain (partly due to the subprime mortgage crisis) and stocks will most likely rise in value over the next several years.

So, if you have a long-term outlook of 3-5 years, the stock is likely to outperform the CD investment and possibly by a large margin. If you don't feel comfortable committing your funds for that long, then you should probably stick with the safety and certainty that CDs offer.

There is more information on this topic in this article: Is Your Money Smarter 'In' or 'On' the Bank?

401(k), Traditional IRA, and Roth IRA

Came upon this brief description of the three tax-advantaged retirement accounts on Morningstar.com and thought it would be a good idea to paste that info here. I would have just linked to their web site, but it's from their pop-up window that doesn't show an address. Anywho, here it is:

401(k)s
401(k) plans, so named after a section of the Internal Revenue Code, are set up by employers as a retirement-savings vehicle. The primary advantage of a 401(k) is tax deferral. First, employees can contribute a percentage of their income from each paycheck to their own 401(k) accounts on a pretax basis. This means the amount you contribute to your 401(k) is exempt from current federal income tax. For example, if you are in the 25% income tax bracket, a $100 contribution will reduce your current tax burden by $25. Second, dividends and capital gains earned inside a 401(k) are not subject to current taxation. In short, 401(k) plans allow you to defer taxation on dividends, capital gains, and a portion of your wages until you begin withdrawing from the plan, presumably during retirement, when you may be in a lower tax bracket. (All withdrawals are taxed at ordinary income rates.)

The amount you can contribute to your 401(k) plan is limited to $14,000 in 2005 and $15,000 in 2006. Thereafter, the annual contribution limit can be adjusted in $500 increments to account for inflation. You also must begin mandatory withdrawals from your 401(k) when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed as ordinary income, and you may be subject to an additional 10% penalty.

Traditional IRAs
Individual retirement accounts are another vehicle for tax deferral. When you contribute to a traditional IRA, the IRS allows you to take an income tax deduction up to the amount of the contribution, subject to income limitations. In addition, dividends and capital gains earned inside a traditional IRA are not subject to tax until withdrawal.

However, there are some important limitations to remember. First, you must be age 70 1/2 or under with earned income to contribute to a traditional IRA. Second, the annual contribution limit is $4,000 from 2005 to 2007. The limit rises to $5,000 in 2008, and thereafter can be adjusted in $500 increments to account for inflation. If you are age 50 or older, you can make additional "catch-up" contributions of $500 in 2005 and $1,000 from 2006 onward. Finally, like 401(k) plans, you must begin mandatory withdrawals when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to an additional 10% penalty.

Roth IRAs
These are typically the best retirement account option for many taxpayers. As with traditional IRAs, interest income, dividends, and capital gains accumulate tax-free. However, the main feature of Roth IRAs is that they are funded with aftertax dollars (contributions are not tax deductible). The upside of this is that qualified distributions from a Roth IRA are exempt from federal taxation.

The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with income up to $95,000 and joint filers with income up to $150,000 are eligible to make the full annual contribution to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59 1/2.

In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you open your first Roth IRA and make your first contribution on April 15, 2005, for the 2004 tax year, your five-year period starts on Jan. 1, 2004. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.