Nickeled and Dimed

All this week on Centsability to Wealth we are going into detail on each of my four steps to financial freedom.  So far we have covered strategies for paying off debt, how to open an emergency fund, retirement accounts and how to open a Roth IRA.  Today is the final step, creating passive income.

What is passive income?

Passive income is any form of income that is derived while an individual is not actively involved.  It is the ultimate achievement in personal finance.  Many people consider the true measure of “financial independence” to be when your passive income equals or exceeds your expenses.

I believe financial independence can mean whatever you want it to mean, however there is no denying the importance and power of passive income.  Create enough of it, and you may never have to work another day again.  Creating the passive income, on the other hand, could take a lot of work and/or money.  Let’s go over some of the different ways to create passive income.

Ways to create passive income

1. Real Estate- Real estate can be an excellent form of passive income.  By buying a property and renting it out to others, any cash flow becomes passive income.
2. Dividends from stocks or bonds- Any dividends paid out from your stocks or bonds is passive income.
3. Network Marketing- The phrase network marketing has a lot of negative connotations thanks to a lot of scams, but there are legit network marketing businesses out there which can create passive income for you.  We will discuss this more in another article.
4. Start an online business- This can be anything from a website that sells goods to a simple blog that makes money off ad revenue.  It takes a lot of work, but there are several success stories from people who have created passive income online.
5. Create a trademark, copyright, or patent- Inventing or creating original content that can be copyrighted, trademarked or patented can lead to passive income.

As you can see, nothing on this list is easy.  Most are either incredibly difficult to create, or cost money.  The good news is, by the time you get to the point of worrying about passive income your debt is paid off, you have an adequate emergency fund in place, and you are fully funding your retirement accounts, so you presumably will have extra money to invest in things that create passive income.

And this is by no means an all inclusive list.  There are plenty of other ways to create passive income.  Basically anything you do can be turned into passive income if you can find a way for it to earn money.

Just because passive income is usually something that is achieved later doesn’t mean you shouldn’t be on the look out for opportunities now.  Keep being disciplined with your spending, funding your retirement accounts and staying out of debt, and you will be ready when an opportunity to create passive income presents itself.

Passive income is not something you achieve over night.  It is the pinnacle of your financial journey.  When you achieve it, you can set your finances on cruise control and enjoy your time however you want. 

Please continue sending any questions, suggestions and story tips to centsabilitytowealth@gmail.com.

All this week we are going into detail on each of my four steps to financial freedom.  On Monday we  discussed the strategies for paying off debt and Tuesday we talked about how to start an emergency fund.  Today we get to retirement accounts and will outline the differences between the two main options; a 401(k) and a Roth IRA.

With the future of social security looking more glim every day and the idea of a company pension to support you through retirement all but extinct, it has never been more important to understand retirement accounts and begin investing in them.  Individual retirement accounts, or IRA’s, allow you to invest your income, up to a certain amount, into stocks, bonds and other investments in order to help fund your retirement.  They also usually offer differing tax advantages and penalties for taking the money out before reaching a certain age.

There are many different retirement accounts to choose from, but by far the two most popular are the 401(k) and the Roth IRA.  Before deciding which is best for you, let’s discuss each and their advantages and disadvantages.

401(k)

A 401(k) is an employer sponsored retirement plan that allows employees to take out a portion of money from their paychecks, place it in a retirement account and earn interest.  All contributions are tax-deferred and reduce the employees taxable income by the amount contributed.

A 401k retirement plan must be sponsored by an employer or an organization. The actual work of administration and monitoring of accounts is usually outsourced to independent banks, mutual fund companies, financial service enterprises and more. As soon as an employee gets a paycheck at the end of the month, he can transfer a portion of it to his 401k account. Types of investments available include mutual funds, stocks, bonds and money market instruments.

Advantages of 401(k)

• Tax-deferred contributions- Allows you to contribute more and also reduce your taxable income.
• High maximum contribution amount- $16,500 for 2009.
• Many employers will match contribution up to certain percent- Many employers offer a company match that will equal any contribution you make up to a certain percentage of your income.

Disadvantages of a 401(k)

• Can be some what difficult to move if you switch jobs- If you switch jobs after starting a 401(k) you will likely want to roll over your account to your new job.  Depending on your job, this could be a little stressful, but definitely not impossible or a deal breaker.
• Earnings are taxed- Unlike a Roth, you will be taxed on all gains when you pull out your money.
• Penalties and taxes for early withdraw- Should an emergency arise (beyond your emergency fund) and you are forced to withdraw any amount from your 401(k) before retirement, you could be charged a 10 percent penalty fee and forced to pay taxes on the previously tax-deferred contributions.

Roth IRA

In many ways, a Roth IRA is the exact opposite of the 401(k).  All contributions must be made after taxes, while all gains made are taken out tax free.  There are also income limitations for participating in a Roth IRA ($101,000 for single individuals or $159,000 for married couples in 2008) and a much lower maximum contribution amount ($5,000 for anyone under age 50, $6,000 for anyone over age 50).

Advantages of a Roth IRA

• All gains are tax free- This could offer you a gigantic tax savings when you withdraw the money in retirement.
• No fees for certain early withdraws- Unlike with a 401(k), there are certain conditions in which you are allowed to withdraw your savings before retirement with no penalty.
• Does not have to be employer sponsored- You can set up a Roth and invest in it on your own, independant of any companies.
• Easy to set up and never have to switch- You can get online and set up a Roth IRA in minutes and never have to worry about rolling it over due to switching jobs.

Disadvantages of a Roth IRA

• Contributions are taxed- All contributions come after taxes, which means less money to invest and higher taxable incomes than with a 401(k).
• Low contribution maximum- Can only contribute $5,000 per year ($6,000 if over 50).
• No company match- Since it is not company sponsored, there is no company match.

So which plan is best for me?

I’m sure you are just about tired of seeing me use this sentence, but as with all the other things we have discussed, it depends entirely on your personal situation. 

You will hear arguments that if you are relatively young, it is better to pay taxes now while your tax rate is presumably lower than it will be later, in which case the Roth is best.  Others will tell you to take advantage of the tax breaks now because you don’t know what the future holds, for you or our tax system.  The advice varies from expert to expert, but it all depends on you. There are a few rules that everyone can follow though.

1. If you have a company match in your 401(k), always contribute at least enough to get the maximum match.  This is free money.  Free money that you pay no taxes on.  There is no excuse for not taking advantage of it.
2. If you are maxing out one account, and still have money to invest, begin investing in the other.

The most important thing isn’t which one you choose, it’s that you choose one and start investing in it.  Invest early and invest often.  Invest the maximum your funds (and government limits) will allow you to.  The magic of compounding interest (will discuss in later article) will make your investments increase many times over.

Don’t let the doom and gloom people around you and in the media discourage you from making the best financial decision you can possibly make to fund your retirement.  The current markets make it even more appealing to start investing now.  If you have not yet done so and your debt is paid off with an emergency fund in place, open a retirement account and start contributing.

Tomorrow on Centsability to Wealth we will discuss how to open a Roth IRA.  Please continue sending any questions, tips and story ideas to centsabilitytowealth@gmail.com. 

Ben Steverman has an excellent article in BusinessWeek called 20 do’s and don’ts for 2009.  After interviewing several of the top financial advisers in the country, Steverman compiled this list of 20 things you should, or should not do with your personal finances in 2009:

1. Don’t try to predict the future.

We are in the midst of an unprecedented market, Steverman says.  Trying to predict the bottom of this market, or an individual stock especially, is a sure way to lose money.  Instead, continue making steady contributions to your investment accounts.

2. Do keep enough cash available.

Here Steverman advocates something Centsability to Wealth believes strongly in, an emergency fund.  “With extra cash available”, Steverman says, “you can avoid selling investments to pay for expenses in an emergency”.

3. Do invest internationally.

International markets have been hit even harder than ours.  And some, like China, still have very promising long-term outlooks.  Steverman argues that this is not the time to bail on your foreign investments, in fact, it may be the time to add more.

4. Don’t try to pick one winning investment. Diversify.

With prominent companies going under left and right, now is not the time to put all your money in one stock.  Stick with the time tested strategy of diversification.

5. Do think about energy efficiency.

Financial advisor Russell Francis recommends taking advantage of $500 energy tax credit that can be used to cover the costs of making your house more energy efficient, by adding more insulation, replacing doors and windows, etc.  The credit was rescinded in 2008, but is back for 2009.  Basically the government will pay you to save money on your energy bills.  Definitely something to look into.

6. Don’t stop contributing to 401(k) and other retirement accounts.

If you have at least ten years before retirement, this is a great time to be investing in your 401k.  The article has a great quote from advisor Sidney Blum, “more money is made at the bottom of a market than the top”.  Amen, Sidney.

7. Do live below your means. Save.

You can only invest if you have money left over each month.  Continue to look for ways to spend less and save more.

8. Don’t make sudden moves.

Decisions based on fear and emotion aren’t good for your finances.  Steverman recommends ignoring day-to-day news and focusing on your long-term investment plans instead.

9. Do pay off expensive debts.

Not many investments are offering the 7 to 20 percent return you can save in interest payments by paying off credit card or car loan debt.  Before you get serious about investing, plug the holes in your boat by paying off debt.

10. Don’t give up on stocks.

“Historically some of the best periods for stock market returns have been during dismal economic times,” says Paul Winter of Five Seasons Financial Planning in Salt Lake City.  Stocks are on sale, they aren’t toxic.  Take advantage of sales on stocks as you would a sale on anything else.

11. Do track your spending.

You can’t cut your spending if you don’t know what you are spending your money on.  Keep thorough records of your spending.

12. Don’t pay high management fees.

It doesn’t matter how high the return on your portfolio is if your fees are eating all the profits.  And in a down market like this, fees can really bite you.  Shop around for the lowest management fees available.

13. Do review your credit reports.

Your credit score may not have ever been as important as it is today.  With an excellent credit score you can borrow money practically for free right now.  Mortgage rates are at historic lows and cars are offering zero percent financing on virtually anything.  But with a less than great credit score you could be left on the outside looking in.  With lenders cutting down you may find it very difficult to get a mortgage at all right now, much less a good rate.  Watch your credit score and do what it takes to get it to the top level.

14. Don’t follow the herd.

Steverman uses my favorite quote from Warren Buffet here “Be fearful when others are greedy, and greedy when others are fearful”.  Don’t jump ship on your investments just because everyone else is.  Instead take advantage of people selling at such low prices and invest more.

15. Do write down an investing plan and budget, and stick to them.

Like we talked about with goals, Steverman highlights the importance of having a specific plan for your finances and sticking to it.

16. Don’t forgo necessary insurance.

Skimping your insurance coverages is not the proper place to save money.  Make sure you are properly protected against worst case scenarios.

17. Do check out your financial adviser.

With more money managers looking like crooks everyday, you would be wise to do a full investigation on anyone you have managing your money.  Ask proper questions and look them up on online databases.  Steverman says the Financial Industry Regulatory Authority’s BrokerCheck is a good place to start.

18. Don’t invest in anything you don’t understand.

Do your homework.  Don’t just invest in a hot stock tip.  Know what your money is going into.

19. Do make sure safe investments are actually safe.

Make sure your bank accounts are federally insured to cover the full amount of money you have in them.  If they aren’t, change accounts.  More bank failures are coming.  Make sure you are protected if your bank comes next.

20. Don’t take more risk than you can handle.

While this is a great time to invest, you should not try to make up all your losses with one move.  A classic mistake is “following one investing mistake by making an even bigger one.”, Steverman says.

Following these 20 dos and don’ts for 2009 will give you a good basis for your financial decisions.