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Thursday, Mar 28, 2024

Personal Finance–Don’t Go Deeper in Debt If Your Income Can’t Bear It

Question: My wife and I are baby boomers. We both want to retire at an early age (63) and be debt-free, but we are burdened with high credit card debt. We currently owe $25,000. I know that seems outrageous, but it has been as high as $33,000. We’ve been playing the balance transfer game for years and have been able to keep the average interest cost on the debt at about 8 percent, but this is a tedious process. I have IRAs valued at $21,000 ($16,000 in CDs and $5,000 in a mutual fund), and my spouse has $23,000 ($17,000 in CDs and $5,000 in two mutual funds) for a total of $44,000. The CDs will mature soon. We have eight years remaining on our home mortgage. The house has a current market value of about $80,000. The mortgage is at 8.75 percent with a payoff of about $23,000. We’re currently paying $465 a month on a 1999 pickup truck, with $17,000 owed, and we own a 1994 Camaro, valued at $8,000. We are planning on trading in the ’94 for a newer model this year and have $2,000 in cash set aside for a down payment. I am 48 and my spouse is 56. I am disabled and receive veteran’s disability of $323 a month, tax-free, and a military retirement pension of $800 a month, after taxes. My spouse works and grosses $20,000 a year. We’re trying to decide how to pay off the credit card debt and be debt-free. Should we continue a long, slow process, or take money from our IRA accounts? What do you suggest? S.F., by e-mail Answer: You need to start with a clean sheet of paper. The very last thing you should be doing is replacing a no-payment car with a car that requires another monthly payment. Your $465 a month payment for the pickup already absorbs about 17 percent of your income. The mortgage payment takes another 20 percent, and minimum payment on your credit card debt probably takes another $375 a month, or another 13 percent of your income that’s 50 percent of your income committed, as it stands. If you buy a new car, there’s a good chance you would have a visit from the repo man before the year is over. I think you can solve your problem, but it will take some radical action on your part. At the moment, you have nearly $1,200 a month in credit commitments your actual mortgage commitment calculates to $335 (the rest of your payment is insurance and taxes), $465 for the car payment, and $375 for minimum credit card payments. My suggestion: Sell the pickup truck and replace it with a vehicle leased for no more than $200 a month. Then get an equity loan on your house. Pay off the credit cards. With the remaining $1,000 a month you’ll be able to pay off the mortgage and equity loan in five years. That will leave you with two years before your wife turns 63 to accumulate money to buy a car that you own payment-free. Another task: Check what your spouse’s projected Social Security payment would be if she retired at age 66. That’s another three years to let your IRA accounts grow and to have her Social Security benefits increase. Think of this extra time as your fallback position. If your wife was born in 1944, she won’t be eligible for full Social Security benefits until she is 65 years and 10 months old. During the same period you should also re-orient your IRA accounts so you can get a higher return. I suggest a one-step solution such as Vanguard Balanced Index fund. It’s 60 percent domestic stocks, 40 percent domestic bonds, has no load fee, operates with a very low expense ratio, and has done better than 87 percent of all domestic balanced funds over the last five years. Think of it as the ultimate couch potato investment but it still beats most of the smart guys who think they can beat the markets. You can learn more about this fund by calling (800) 662-7447. If you’d like to consider more active management, Invesco Balanced and Janus Balanced, both no-load funds, were among the few that did even better than Vanguard Balanced Index. Q: What is the rule of thumb about whether it makes sense to put after-tax dollars in a 401(k)? My husband (50) and I (40) contribute 20 percent of our salaries to our 401(k) plans. My husband does not hit the maximum pretax contribution, but I do and then I must convert to post-tax contributions. We fully fund our Roth IRAs and have $70,000 in equities outside of retirement accounts. Would it make more sense to buy and hold individual equities with what would have been my after-tax 401(k) contribution? Stock appreciation won’t be taxed until I sell, so the tax deferral of the 401(k) is irrelevant. When we retire (10 to 15 years) and begin to sell stocks, the taxes on the capital gains will be 20 percent, versus a marginal tax rate of at least 28 percent for 401(k) withdrawals. Our 401(k) funds have been doing extremely well, and I don’t think I could have beaten their return over the last two years. Maybe it’s worth the tax penalty to have the money professionally managed. Any thoughts? L.E., Cincinnati A: Qualified plans are an area of tax law and accounting that is extremely complicated, and where small errors can be very expensive. For that reason, I suggest you keep your tax-deferred money in one place and your taxable money in another. When you hit the max on your 401(k), put your additional funds in another investment. This could be a portfolio of individual stocks with all the advantages you suggest or it could be in a mutual fund that is managed for tax efficiency. While index funds are the first thing that comes to mind in this area, it is possible to be managed and tax efficient. The end result is that tax efficiency can be a good alternative to tax deferral. Let me give you an example. Thornburg Value Fund A shares have a 94.75 percent tax-efficiency figure (over the last three years) from Morningstar. That’s not so far from the “titans of tax efficiency,” such as the Vanguard Index 500 (96.19 percent) or the tax-managed Schwab 1000 (98.21) fund. Thornburg Value provided a return of 36.99 percent in 1999, putting it in the top 19 percent of its category. While it is possible to buy individual stocks and hold them, tax avoidance really shouldn’t influence what stocks you hold and what stocks you sell. Unless you are a relatively sophisticated investor, ready to make buy-and-sell decisions, investing in a good, tax-efficient mutual fund is likely to have the best payoff. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: [email protected].

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