Get With The Plan: December 26, 2010

122610Joe, 36, and Erin, 32, want to supercharge their finances while they can.

They’ve saved plenty in cash accounts and in retirement savings, and they even add extra to their monthly mortgage payments.

“What do we do with our extra money?” Erin asks. “We think our retirement funding is on track and we have about two years of funds to cover our core monthly costs. Should we just keep putting money into savings or up our retirement, or prepay our mortgage, or do something else?”

The couple, whose names have been changed, have set aside $106,800 in 401(k) plans, $52,000 in IRAs, $22,000 in mutual funds, $133,000 in savings and $4,000 in checking.

The Star-Ledger asked Michael Pirrello, a certified financial planner with Mill Ridge Wealth Management, to help the couple make the most of their extra funds.

“Joe and Erin are on a well-paved and smooth road to financial freedom,” Pirrello says. “Currently, all the lights are green, but properly navigating the inevitable bumps in the road will be the key to reaching their desired financial destination.”

Pirrello says the couple has secure jobs with good earnings and advancement potential, no debt other than a very sound first mortgage and plenty of savings.

He says they are the exception to the rule in this recession, given that their biggest question is not how to pay bills, but what to do with extra savings.

Pirrello says Joe and Erin have adequate life and health insurance coverage, and while they don’t expect any big inheritances down the road, they also don’t expect any family members to be financially dependent upon them.

They also have a good mortgage with a fixed rate of 4.75 percent, and they are paying an additional $500 per month toward the principal. At that payment, Pirrello says, the mortgage will be fully paid in about 18 years.

The couple’s two main areas of financial concern are retirement savings and how to properly manage their additional savings.

Joe says their retirement goal is for “comfortable living, similar to our current lifestyle, house paid off, plenty of money to travel.”

On retirement: Earlier in 2010, Erin and Joe converted their traditional IRAs to Roth IRAs to provide for future tax-free growth and retirement distributions.

“This strategy makes sense for them because of their relatively young age and ability to pay the conversion tax with funds that were already set aside,” Pirrello says.

He says at their current rate of savings and with assumed returns of 7 percent pre-retirement and 5 percent post-retirement, Erin and Joe are on track to live through a long retirement based off of 70 percent of their projected final year income of $360,000.

“However, retirement planning at the ages of 36 and 32 leaves much to be desired due to the unpredictable nature of the investment markets, economy and tax legislation,” Pirrello says. “While they do not have any other pending financial commitments and their cash flow allows, Joe and Erin should focus on trying to front-load their retirement savings as much as possible.”

Pirrello recommends they both increase their 401(k) retirement contributions to reach the annual IRS limits ($16,500 in 2011) and continue to make the maximum non-deductible IRA contribution ($5,000 for 2011) to a traditional IRA.

“Because they are not eligible to make contributions to a Roth IRA due to their high income, contributing to a traditional IRA will allow them the potential for future Roth conversions as allowed by current and future tax legislation,” he says.

With U.S. interest rates at historical lows and the expectation that rates will stay that way for some time, Joe and Erin are faced with a dilemma of what to do with their accumulated savings.

They have $133,000 in a money market that is earning less than 1 percent, and they’re adding more than $2,000 per month to the account. Pirrello says they need to address their return on this money.

“Sitting their savings in a money market at an interest rate of less than 1 percent is just not an option,” Pirrello says.

He recommends the following strategy for the funds:

  • $60,000: “6 month + account.” Pirrello says this account would represent approximately six months of living expenses, plus extra for unexpected expenses and vacations. Half of the funds could be left in their current money market and the rest should be invested in a low-cost, ultra short-term high-quality bond fund with a yield of 2 to 3 percent. If funds are needed for car and home repairs or a vacation, this is the account they should tap, Pirrello says, noting it should be replenished as needed to maintain the $60,000 balance.
  • $60,000  $100,000: “1- to 5-year account.” This account will represent funds that can be earmarked for a new car, a new home purchase, possible child expenses and any other significant expense that may arise over the next five years. Pirrello says these funds, if never used, will ultimately augment the couple’s retirement savings. Until Joe and Erin have a clearer future, their goal should be to keep this account in the $60,000 to $100,000 range.

This account should be invested in a 60/40 stocks/bonds low-cost mutual fund allocation with 20 percent of the stock allocation focused in emerging and international markets, he says.

If more than $100,000 ends up in the account, the overflow should fill a 10-plus-year investment account that will be more properly earmarked for retirement and more aggressively invested.