I occasionally get questions from readers and try to answer each one to the best of my ability, but there are some questions that get asked more than others. For these types of questions I like to turn it into a post so that it can help even more people.

One of the questions I get a little more frequently than others has to do with emergency funds and credit cards or lines of credit. We always stress the importance of building up an emergency fund, but it can sometimes take a while to get to that three, six, or eight month target. So, people often wonder if it’s acceptable to work with a relatively small emergency fund while holding on to a few unused credit cards or a line of credit to make up the difference. So, what’s the verdict on credit cards and emergency funds?

Using Credit vs. Savings

Even if you have unused credit available to you in the event of an emergency it’s still vital that you build up a cash emergency fund. While it’s a good idea to have a credit card without a balance out there and ready in case something does come up, this should be an absolute last resort and not even thought of as part of your emergency fund. There are a few reasons why using credit over savings could be harmful.

First, cash is money that you have and credit is money that you don’t have. If something comes up and you have to find some money to pay the bills or other unexpected emergency, if you use cash you’ve saved you’ve immediately satisfied that need. On the other hand, if you pay off that expense with a credit card, you haven’t relieved yourself of that expense. All you’ve done is basically delayed the payment. And for that convenience you’ll be charged interest. So, cash eliminates the emergency, credit just delays it.

Second, you could be making the situation worse by introducing a new monthly expense which comes in the form of the credit card payment. Let’s say you have a $5,000 emergency come up. If you have that money set aside in savings it’s a quick one-time payment and you won’t have to think about it again. But if you are forced to use a credit card to pay that $5,000 you’ve only transferred the emergency from the initial bill to a credit card and will begin with monthly payments. A $5,000 balance on a credit card could easily amount to a $100-$150 monthly minimum payment. If your budget allows, that might not be a problem. But if your emergency extends for very long you could find yourself suddenly in a bigger emergency when you can’t make the minimum payments on that credit card.

Secured vs. Unsecured Debt

Make sure you understand the difference between the two when using credit to get through an emergency. A lot of people tend to treat their home equity loan or home equity line of credit as an emergency fund, but this is a bad idea. This is secured debt, which means the money you borrow is backed by an underlying asset–in this case, your house. When you can’t pay off a secured debt the bank can take the property back.

Just like in the credit card example above, if an emergency comes up such as a job loss and you tap into a home equity line of credit to keep things going for a few months, you’ve essentially just put your house on the hook for your emergency. Now, you not only have a mortgage payment on your house but a home equity loan payment, so what happens if you can’t find a job as quickly as expected? Sooner or later those monthly line of credit payments may be impossible to pay so now your financial emergency just expanded and puts you in a position where you could lose your house.

If you must rely on credit to get through a financial crisis, make sure you tap unsecured debt like credit cards first. Sure, you’ll pay a higher interest rate and may not have as much credit available, but the damage done in the event of a prolonged emergency can be minimized.

Consider Your Options Carefully

It’s ok to temporarily have some available credit out there as an added safety net if a true emergency arises, but it should in no way substitute for actual savings. Just because you have about two months worth of savings set aside and four months worth of expenses available in the form of credit doesn’t mean you have a six month emergency fund. It may be good to know that in a worst case scenario that you have that going for you, but you should still be working to build up the cash in your savings. Don’t stop saving just because you have a little bit saved along with a sizable unused credit line.

Credit can work in a pinch, but don’t get complacent and fall back on your savings. And also make sure your savings is working for you. I know interest rates aren’t as good as they used to be, but you’ll still want to earn a little bit of extra money in the form of interest so stick with a high-yield savings account if you can. Then, make sure you’ve created an automatic savings plan so that you have money going into the account each week, bi-weekly, or monthly. When you put your savings on autopilot you won’t even have to think about it, and before you know it you’ll have enough cash set aside that you won’t even have to think about using credit to get through an emergency.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: I Don’t Have Much Savings So Can I Use Unused Credit as an Emergency Fund?

Occasionally I receive questions from readers who contact me, and I do my best to answer everything that comes my way. One question that has come up more frequently in the past few months has to do with saving for retirement and the major losses we’ve seen in the stock market. 

One of the main concerns has been with the fact that it seems like everything you put into your retirement account is being lost in a matter of months. Obviously, this doesn’t make you feel good about your decision to save and invest, but is it really that bad?

A reader asked:

Hi, Jeremy. I’m 31 and for the past year or so every time I get my statement in the mail I’m losing everything I put in. Last quarter I put around $1,500 into my 401k plan, but the statement showed a loss of -$1,613. I actually lost more than I put into my account. I know I should be saving for retirement, but I could put this money in the bank and at least come out even. It just makes no sense to keep investing right now. Am I wrong?

I’m sure many of you can relate to this story.  The past year and a half have been difficult to say the least. This is especially true for those who are still relatively new to investing. If you’re just starting out and see that everything you’re putting in is vanishing a few months later, it’s easy to feel it’s not worth doing and you’re just throwing money away.

Don’t Think of it Like a Bank Account

The biggest problem many people have is they get their quarterly investment statements and think of them in terms of a bank account. Obviously, if you deposited $2,000 in your savings account at the bank only to get your statement a month later and see a lower balance, you’d be pretty upset. That’s because money in the bank is just money. You didn’t buy any assets with that money, and it is just a place to safely put your cash for a later date.

An investment account isn’t the same. You have to remember that you’re actually exchanging your money in return for another asset. In most cases, this means buying shares of a mutual or index fund. The important thing to remind yourself is that if you bought 100 shares of XYZ investment, you still have 100 shares regardless of what your statement says it is currently worth. You have actually purchased something, and in the future you may see the value of your asset change.

Even though your statement shows a loss on paper, think about it in terms of actually owning assets. You still hold shares of your investments, and nobody took those away from you. They have just been temporarily devalued by the market.

You Haven’t Lost Anything Until You Sell

You’ve probably heard this before, but it’s true. The losses are only paper losses until you sell. Going back to what was discussed above, you actually own shares of an underlying asset. The value will change on a daily basis, but once you sell, you no longer own that asset. That’s when your losses are realized. Once you no longer own something, you can’t benefit from any future appreciation. Of course, you can invest the proceeds in something else, but any loss you had on paper for that particular investment is locked in stone once you sell. 

Try to resist the urge to see the gain/loss column on your statement as an actual gain or loss. I know, it’s hard to do. When you’re talking about thousands of dollars being “lost” in a short amount of time, thinking about it in terms of a paper loss provides little solace. Think back a few years ago when your gain/loss column was showing gains instead of losses. You were happy, right? Looking back, it’s clear that you didn’t really gain anything unless you sold back when prices were high and locked in a profit. The same thing holds true now.

You Want to be Investing Now

When you go grocery shopping, do you try to find things on sale? When you’re looking to buy a new car, do you try to get the best deal possible? Of course you do. We’re always looking for ways to find the best value. So, why does it feel so different when it comes to investing? If you can buy the same stocks today for 50% less than a little over a year ago, why wouldn’t you?

Of course, it’s all relative. Stocks are “on sale” right now, but compared to what? Some experts say stocks are just falling back to where they should be valued while others say many stocks are truly cheaper than they should be. In the end it doesn’t matter. The fact is that most stocks are cheaper now than they were a year ago. Were you buying in 2006 and 2007? As long as returns were positive, you probably didn’t think twice about investing even if you were buying at historically high points. So, now that stocks have come down dramatically, why would it be a good idea not to buy? Remember, you make money by buying low and selling high, not the other way around.

There’s obviously no crystal ball, and we have no idea what’s going to happen. Stocks may continue to fall for some time. It could take a few years to begin to see recovery. Or for all we know, there could be a 10% rally next week. Since nobody knows what’s going to happen and when, the best thing you can do is keep up with your plan and be glad that you’re picking up some shares at a lower price than you were buying a year ago.

Don’t Forget About Tax Benefits

The argument to divert money into the bank as opposed to a retirement account may make sense on the surface. If you’re putting your money into a safe cash account, you can’t lose anything. But you are in fact losing some important tax benefits. If you’re investing in a pre-tax retirement account like a 401(k) or a traditional IRA, you’re giving up an immediate tax break on those dollars. If you’re investing through a Roth IRA, you’re giving up tax-free withdrawals on those funds and any gains in the future. And in either situation, you’re giving up tax-deferred growth. The effects of deferring taxes can have a significant impact on the size of your nest egg 20 years from now, so giving that up for the sake of safety granted by a savings account can be shortsighted. 

Keep Your Goals in Mind

Above all, consider your situation and your goals for your investments. If you’re like the reader and have 30 years until you’re looking to begin using the money, be thankful that you have that kind of time left and thankful that the market has presented a buying opportunity. If you are in a situation where your investments are going to be needed relatively soon, for retirement or otherwise, you’ll have a different set of goals. If that’s the case, make sure you’re investing in a way that’s appropriate for your situation.

The big thing to remember is that there’s no right or wrong answer. Your tolerance for risk and objectives for your money will be different than the next guy. Even so, make sure you’re armed with information before making a decision. Remember, your investment statements are not like bank statements. You’re actually buying assets, and you haven’t lost anything until you sell. And if you’re investing for the long-term, the money you invest today will pay off a few decades from now.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: It Feels Like I’m Just Throwing Money Away, So Why Should I Keep Investing?

As I was browsing some of the news on CNN, I came across a video that had the title: Foreclosure Family Camps Out, so I had to see what that was all about. I was curious to see where the blame was going to be placed, and what the details of the story were. We hear a lot about the subprime mess, real estate prices plummeting, and irresponsible buyers, each of which play a key role in the big picture. But for this family who is now living out of a camper, who would you put at fault? Let’s look at the details from the story.

The Couple’s Story

To better understand the circumstances around this foreclosure, let’s take a look at some of the details from the story:

• 2,700 square foot house in Las Vegas, Nevada.
• Dual incomes.
• Home price of $265,000.
• Purchased with no money down, interest-only loan.
• Home value doubled in just a few years providing a lot of equity.

The First Mistake

Looking at the information above, this represents a large number typical families, but what is wrong with this picture already? I’m sure most of you recognize the real problem is that the purchase was made with no money down, and with an interest-only loan. We know this is a problem, but from the reaction of the woman in the video, she knew that this was too good to be true as well. She says, “We can get this for $265,000 with no money down? Oh my God!”

So, if you’re shocked at being able to purchase a home valued at over a quarter-million dollars without putting a single dollar down, yet go through with the sale anyway, that is the borrower’s mistake. On the other hand, banks shouldn’t have been offering these loans to begin with, so that also scores a point for the lender as well. I’d score this round of mistakes a 1-1 tie between the lender and borrower. Both parties were greedy.

Second Mistake

So far, this has played out like many other home purchases. People with steady incomes are looking for the “house of their dreams”, and seek out a home in the rapidly growing real estate market. They are shocked to find out that they can purchase a lot of house without even saving a penny for it, so they go through with the deal. As long as they earn decent income, they are living the American Dream.

Then, tragedy strikes. Someone loses their job, thus losing a stream of income. Suddenly, bills become harder to pay, and some will inevitably be late, including the mortgage payment. For most people, what happens when you’re faced with a sudden emergency like a job loss? Hopefully, you are able to turn to your emergency savings that can help you keep up while you try to find another suitable job.

In this case, this couple went straight to the equity in their home. Of course, when the real estate market is allowing your home to double in value in a short amount of time, why not? People see this as free money because they purchased real estate as an investment. Unfortunately, you’re only taking on more debt just to pay off other debts. This is almost always a losing battle.

It doesn’t disclose how much equity they took out, but it said that the home equity loan or line of credit increased their monthly payments by 57%. Given the sharp increase, I’m guessing they didn’t just take out a couple thousand to get them by until they found another job. They probably took out tens of thousands of dollars, but I won’t speculate.

In this round, I have to give a point to the borrowers for failing to plan appropriately for an emergency. Of course the bank is going to accommodate someone who has built up over $200,000 in equity in their home, and for all the bank knew, she was going to be getting another job and they would be able to continue to make payments.

The Nail in the Coffin

To make matters worse, when they tried to sell the home in a now depressed market and couldn’t, they took out another $35,000 loan to help pay the mortgage. Since they already tapped into the equity in their home, and now had to seek additional debt to pay the mortgage, they took out another loan.

It said that their new monthly mortgage payment with the home equity loan was just under $1,200/month. So, how long was this going on? If you borrowed $35,000, that could theoretically pay the mortgage and equity loan for 29 months (barring any changes in the loan or moving beyond the interest only period). Of course, you’d also be making monthly payments on the $35,000, but you could still assume that this influx of money could keep their mortgage current for at least 12-18 months.

Again, there are no time frames or interest rates being paid given, but the circumstances are pointing to a lot of bad decisions on behalf of the borrowers. With the money borrowed, and still having one steady stream of income, this borrowed money should have been able to bridge the gap until the woman could find some source of income.

They Blame the Lenders

This couple blames the lenders, and who wouldn’t in this type of situation. They go on to say that the loan documents are confusing and hard to understand, which is true. There is no doubt that understanding every little thing in the mortgage paperwork is extremely confusing for the buyers, and the lenders can make unfavorable loans look quite good. So, the lender is certainly not getting off the hook for promoting an unsuitable mortgage to people who don’t fully understand it.

Is There More to the Story?

While there are certainly parts of this story that can put some of the blame on each party, I think there is a lot more to this kind of story than meets the eye. This story didn’t mention what their incomes were, but given the fact that they had to take out another loan because they couldn’t afford the $1,200/month even after taking out home equity leads me to believe that there were some other significant monthly expenses in play.

Were they making payments on that camper while still in the house? What were their car payments like? Did they have other debts? Did they have any retirement funds to tap into, or were they saving for retirement at all? We know they didn’t have money for a down payment or sufficient emergency funds, so I’m guessing that even with dual incomes, they were living pretty close to paycheck to paycheck as it was.

What do You Think?

So, I’ll leave this up for discussion. What do you think about a scenario like this one? I feel that there is certainly some blame to go around, and with the facts provided and some basic assumptions from these facts, these people probably shouldn’t have purchased a home in that price range anyway. Sure, the lender probably shouldn’t have been offering this easy money to people who probably couldn’t afford it, but even so, this foreclosure was ultimately a result of job loss. Job loss is, and has been the number one reason for foreclosure for decades–well before these more exotic loans were being sold. So to me, it looks like a complicated case of a lack of planning, lack of common sense, and greed (on both sides).

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Couple Living in Camper After Foreclosure – Is it the Lender’s Fault? You Decide

This question actually came in just before I wrote about using Morningstar to track your investments against an appropriate benchmark, but it is certainly worth answering for the benefit of others as well. Understanding what you should be comparing your investments to will give you a clear picture of how well you’re doing, and whether or not you need to make changes.

Don’t Listen to Friends or Co-workers

This is a big mistake. How many times have you been having lunch in the break room when another co-worker begins bragging about their investment performance? They might be spouting off 20% returns, and you begin thinking to yourself about whether or not you’re experiencing the same kind of performance. Entertain them by listening to their story, but don’t rush back to your computer and pull up your 401k statement to see if you’re earning 20% as well.

The problem is that everyone has different levels of risk tolerance and investment objectives. Just because your brother is invested in some micro-cap China fund and doubling his money doesn’t mean it is something you should be invested in. There will always be people making more than you, and there will always be people making less than you. The key is determining whether or not your specific investments are doing what they are supposed to.

Use Benchmarks to Measure Your Success

The only way you can accurately determine how well your portfolio is performing is to compare it to a similar benchmark. If you saw a return of 40% last year, you probably think that is fantastic, right? Well, what if the benchmark for a similar portfolio returned 60% over the same period? Now your investments don’t look so hot as you’ve left a lot of money on the table.

I’m not going to go over the process of finding a benchmark step-by-step, since you can read that in the article I wrote about using Morningstar, but the basic premise is that you need to first understand how your portfolio is constructed. Is it heavy on domestic large-cap? Does you have a sizable bond position? Are you focused on international companies? If you don’t know what your investments are made of, you’ll never be able to accurately compare it to the right benchmark.

Check Regularly, but Not Too Often

You certainly want to keep tabs on your performance, but don’t fall into the habit of checking too often. The markets are volatile, and over the course of a few weeks or months, you can see some variation between your holdings and benchmarks. That’s fine in the short-term, but you will want to monitor your performance about once, maybe twice a year.

If you do notice that your small-cap growth portfolio is lagging a small-cap growth benchmark by more than a few percentage points, you may want to examine your holdings and find out why. The same goes if you find your holdings significantly outperform the benchmark. In many cases, it is simply due to style drift. This is when the managers begin to go astray from the fund objectives. It might be a growth fund, but they could be investing in more value stocks in an effort to improve performance. This can ultimately throw you off your target asset allocation.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: I’m Investing Regularly, but How Do I Know if I’m Doing Well?

When times are tough and you can’t find the money to pay all of your expenses, where do you turn and how do you decide who gets paid? Of course, in a perfect world we would all have sufficient emergency funds to cover these types of situations, but many people are faced with this question every month and don’t have the money saved up. While you may incur late charges or possible dings to your credit score, there are priorities you can set to ease the pain as much as possible.

1. Housing comes first. This is especially true if you own a home. Your mortgage payment should be at the top of the food chain. Your home provides shelter, it is one of your greatest assets, and it is a great mark to have on-time mortgage payment history on your credit report. Above all, make sure you are making those payments. It wouldn’t make sense to go into default because that cell phone bill you just paid required your mortgage to be paid late. Your housing expenses should also include any insurance, which may be part of your mortgage payment anyway. If not, it should be a top priority as well.

2. Don’t forget taxes. I’m not just talking about Uncle Sam, but this includes property taxes as well. If you are employed, chances are you are already paying taxes on a regular basis, but if you are under-withholding you could be faced with a steep tax bill at the end of the year. Your best bet is to have the right amount taken out of each pay check, but if that isn’t possible or you find yourself owing taxes, don’t delay in filing or paying. The same thing goes for property taxes. Failure to pay can put a lien on your home.

The penalties are stiff, and the IRS has no problem garnishing your wages or taking property to get their money. The good news, at least with the IRS is that they do have options available to assist when you can’t pay your taxes. Using an installment plan or reaching an agreement with them should be a last resort, but they are options.

3. You better make those car payments. The next item in line, especially if you require it to get to work every day, is your auto loan payments. Again, this is a secured loan, which means if you fail to make payments on time, not only can it affect your credit, but they can recover the property. Losing your primary means of transportation could cost you your job if you don’t have an alternative. Without a job, you’ll never be able to pay the bills. If being unable to pay your bills is a recurring theme, this is one of the first places to look at cutting costs by finding a cheaper vehicle. Auto insurance should be lumped in with any loan payments and considered just as important.

4. Begin looking at credit cards. Once you have secured your essential payments for your housing, tax obligations and transportation, you can begin looking at paying those credit card bills. Obviously, you want to stay current with these so you can keep your credit report clean, interest rates low, and avoid late fees. Don’t jeopardize your home or other things listed above just to try and avoid a late fee or negative mark on your credit score.

If you do have money left over to put toward credit card bills, pay at least the minimum. If it takes minimum payments on 4 different cards just to make all of the payments, then do that. It is better to only pay the minimum and keep the account current than to try and pay more and end up short on another card and have a late fee tacked on.

If you don’t even have enough money to make the minimum payments on all of the cards, you have to prioritize. First, realize that if you can’t make the payments, you’re going to be late and there are consequences. The best you can do is try and limit the negative impact. First, check to see if there are any grace periods on any of your cards. You may be able to squeeze a few extra days until payday and still avoid a late payment. If that is of no use, you’re probably going to want to look at the card with the highest balance. The reason is that if you’re late, they are likely to increase your interest rate. 29.99% on a $5,000 balance hurts a lot more than 29.99% on an $800 balance.

Finally, remember that late payments typically aren’t reported to credit bureaus until they are over 30 days past due. You may still have a late fee or a change in interest rates, but if you’re a few weeks late you’ll probably still keep that credit report free of a late payment mark. And, if it is your first late payment with that issuer, a phone call may actually get the fee removed or the rate dropped back down. Unfortunately, if you make this a habit, don’t expect any relief.

5. Utilities are often the last resort. You may think that keeping the lights on would be a top priority, but in reality you have the most latitude in making payments compared to the rest of the things on this list. First, many utilities are optional and aren’t a necessity to life. Things like the cable and telephone are good examples. If you fail to make your cable payment, they shut it off and possibly report it to the credit bureaus. Losing cable is better than losing a home or having your wages garnished.

When it comes to the more important utilities, such as electricity, sewer, water, or gas, you will want to try and make these payments, but doing so late might not be as bad as being late on a credit card. Most electric or gas companies have very low late fees, and in some cases it may just be a couple dollars. On top of that, it generally takes an extended period of being late before service is actually shut off. The best thing to do if you find you are unable to pay the electric or gas is to call your provider and explain the hardship. Most offer assistance or special payment plans for those in financial need.

When it comes to something such as sewer, you may actually have to place more importance on that bill. In some places, being late on your sewer bill could eventually result in a lien on your property, so be sure to check and see if that applies. But with most utilities you’ll pay lower late fees than you would on a credit card and they are much more flexible when it comes to being unable to make payments, so most utilities should be one of the last items to pay.

Final Thoughts

As always, you should be trying to make all of your payments on time and in full, and this shouldn’t imply that it is good practice to make late payments, but the reality is that there are times when that just isn’t possible and you have to make the best of it. Also, keep in mind that these are just general guidelines. If your situation involves alimony or child support payments or such, these could take priority given the legal implications, so you have to analyze your situation carefully.

In the end, if being unable to pay your bills is becoming a regular habit, it is time to sit down and think about why this is and make some changes. The occasional emergency happens, but when it happens every month and every year, you need to really take a look at your situation to get out of that rut.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: I Can’t Pay My Bills! What Bills Should I Pay First?

Occasionally I receive questions from readers that bring up good topics that should be addressed for everyone, and recently I had one in regards to life insurance. The question was:

Since whole life insurance has a cash value, wouldn’t that be better than a term policy?

On the surface, this would make sense. A whole life policy does in fact build up cash value over time, whereas a term policy is “use it or lose it”, meaning if you don’t die before the term is up, you get nothing out of it. Even though building up cash may sound better than not, it is important to understand how a whole life policy actually works.

Whole Life Insurance

Whole life insurance is designed to pay out a predetermined benefit upon death, while also building cash value via an investment component. There are various types of whole life policies, from universal, variable, and traditional, but they are all the same aside from how the cash value portion is invested. The problem with whole life is that not only are you paying for the coverage premium, but you’re also paying into the cash value portion. This makes the premiums much higher than term insurance.

Rate of Return and Fees

A typical whole life policy will have an internal rate of return, which is how much interest your cash value will earn after fees and expenses are deducted. Unfortunately, most whole life policies are like mutual funds with high expense ratios; after you factor in the annual fees, the actual return is minimal. In some cases you may only earn a couple percentage points. You’ll also want to be aware of penalties or fees incurred when canceling a policy, as these can be quite steep.

Why Term is Better

Even though you may never receive a payout from your term policy, remember, you are just buying protection for your loved ones. Insurance always seems like a waste when you never see the rewards, but if you don’t have any coverage and the unfortunate does happen, the results can be devastating. So, what seems like a better deal; paying a lower premium that builds no cash value, or paying a much higher premium to earn 3% on only a fraction of the amount?

For working adults, term is almost always the way to go. Typically you purchase insurance once you get married and/or have children. Once the kids are out of the house and you’re beginning to approach retirement, your need for life insurance drops rapidly. This is why a 30 year old would be perfectly fine with a 30 year term policy.

Does Whole Life Have Any Use?

Whole life policies do have their place, just typically not for working adults. These policies can provide significant wealth transfer and estate planning benefits, but are more than likely far too costly for someone in their 30s or 40s. You really need to be careful when dealing with an insurance salesman as they can do a pretty good job at making whole life sound like an investment. Granted, there is an investment component, but you can save money by buying a term policy and earn far more by investing the difference elsewhere.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: Since whole life insurance has a cash value, wouldn’t that be better than a term policy?

I recently received this question via email and since it is probably the most asked question I receive at work as well I figured it would be a good idea to tackle it here. Everybody wants to know how much they should be saving and how large their account should be once they reach retirement. There are two methods to help guide you.

Rules of Thumb

The most common method is simply by using one of the general rules of thumb about retirement income. For years people have been told that you need to earn 75-80% of your pre-retirement income during retirement to maintain your lifestyle. This is a fine place to start but there are simply too many problems with this method.

First, we can’t predict the future. We can make some assumptions as to why we will need less income during retirement such as not having a mortgage payment or no longer commute to work but nothing is certain, especially if you have quite a while yet before retirement. Another huge factor is health. While you may not have a mortgage payment during retirement you could find that you replace that with high insurance premiums or medical care that wasn’t expected.

Creating a Detailed Estimate

A better way to determine how much you should save up for retirement would be to create a detailed estimate based on your specific situation. This means sitting down and taking a look at exactly what expenses you will or won’t have in retirement, what sources of income you will gain or lose, and any lifestyle changes you may have.

Some people will still carry a mortgage while others won’t. Some people may choose to buy a second home or move to a new location in retirement. And depending on what you do during retirement will have a huge impact on your income needs. Maybe you want to travel overseas frequently or maybe you want to join that private golf club you’ve always dreamed of, or maybe you plan on starting a business. You may find you can live comfortably on 25% of your pre-retirement income or you may find you need 150% of that income to reach your goals.

The problem with this method is that this really works best for those who are approaching retirement within maybe the next 5 to 10 years at the most. Beyond that it is difficult to get a real grasp on your financial needs because your situation may still change. For those of us in our late 20’s and 30’s we have to rely on assumptions for the most part. We really don’t know where our careers might take us, how our income grows and what our plans are 30 years down the road.

What The Experts Say

A relatively new study done by a few experts was published in the April Journal of Financial Planning to tackle this exact topic. The study aims to address the following:

1. The annual cash flow needed in retirement
2. The capital needed to generate this lifetime retirement cash flow
3. The annual savings needed to build the capital that will provide the retirement cash flow

An interesting note as to why this study is a bit different can be summed up with this:

We used a more sophisticated approach by using the retirement ratio of 80 percent based on pre-retirement net income as defined as gross income less retirement savings. We used net income because someone who saves for retirement has reduced their pre-retirement living expenses and, for most, it typically follows that they also reduce their post-retirement expenses. For individuals who are saving a lot, this can be significant. Lower retirement expenses means less needed capital. You could say the more one saves, the less one needs to save.

In the past the assumption was simply based on gross income. If you earned $50,000 just before retirement then you need to have $40,000 coming in during retirement. This study factors in savings because if you are saving money each year for retirement, once in retirement you won’t be saving and instead withdrawing so that shouldn’t count towards your required income. For example, let’s say you make $50,000 a year and you are putting $6,000 into your 401(k) each year. Instead of just taking 80% of $50,000 you would take 80% of $44,000, or a retirement income of $35,200.

Capital Required to Generate Income

While it is fine to make estimates about how much money you need in retirement, whether it is based off 75%, 80%, 120% of your income the other big question people have is how much money does it take to generate that stream of income? When I meet with clients they are often quite distressed. They hear things in the media about how they should have over a million dollars saved up and with $150,000 in their account and 5 years until retirement they think it is the end of the world.

The same study talks about how to estimate how much capital will be required to generate this stream of income. It goes into detail using mortality rates, social security, the Monte Carlo simulation and so on. Since it is complex I won’t go into detail here but I encourage you to check out the study and take a look at some of the tables they have provided that give some sample income levels you can use to compare with your own situation.

What This Means For You

After all of this discussion you are probably just as confused as before. Making general assumptions only goes so far, yet if you’re getting close to retirement and put together a detailed estimate you’ve already missed out on a lot of time needed to save, so what should you do? Ultimately you shouldn’t get hung up on some of the numbers out there. Just because some talking head says you should have a million dollar portfolio by age 65 doesn’t mean that is what you should strive for, just as the rule of thumb saying you need to save 10% of your income or have 80% of your income during retirement. People are unique and everyone’s situation is different.

Use these guidelines as a starting point. Read the study and go over some of the examples they provide. While in the end they are still general assumptions they are a great place to start. It is then up to you to monitor your progress and make changes as things in your life change. It is hard to say where life will take you so your actual savings goals may change significantly. If you start saving early and find out you’re saving more than you need to that is a good problem to have. It doesn’t hurt to overestimate because you can do even more in retirement or leave more to your heirs or charity, but if you realize at age 50 that you haven’t saved nearly enough you can’t go back in time and fix it.

Resource: National Savings Rate Guidelines for Individuals 

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Reader Question: How Much Do I Need to Have Saved Up When I Retire?

A reader recently sent an email asking whether or not they can deduct the commissions they paid to trade stocks within their brokerage account. Since this is a great question that may apply to others I figured it would be a good idea to address it on the site. So, can you deduct commissions paid to brokerages for tax purposes?

Ultimately, the answer is yes, but not in the normal sense of your typical itemized deductions as you would see on Schedule A. But first, why do these commissions receive special tax treatment? The reason is that when you purchase stock you are obtaining a capital asset. To obtain this capital asset there are capital expenses. These associated expenses can then be used to adjust the cost basis for tax purposes. So, while you don’t specifically itemize the individual commissions they are automatically adjusting your cost basis which reduces the value of the capital gain when the stock is sold.

Example

Let’s say you want to buy 150 shares of a stock that is trading at $20 per share. This would cost you $3,000. On top of the actual cost of the stock your brokerage charges a commission of $20 for the trade. Your actual cost to obtain this stock is $3,020.

Assuming the stock goes up in value to $25 per share and you decide to sell, your stock position is worth $3,750. To place the sell order your broker again charges a commission of $20. When you subtract the sales commission from $3,750 you end up with a net sale of $3,730.

So, while the actual captain gain of the stock from purchase price to sale price is $750, your actual net proceeds or taxable gain is only $710 ($3,730 – $3,020) . This net sales price is generally what is reported to you by your broker in your annual 1099B form but it is important to make sure you are accounting for the commissions when reporting your capital gains at the end of the year. Again, you don’t have to go back and add up all of your trading commissions and itemize those on your return, but instead they are adjusting your cost basis at the time of the purchase and sale.

Other Considerations

One thing to note is that this only applies to regular taxable accounts. Commissions generated by trades inside a tax-qualified account such as traditional or roth IRAs don’t matter. Since you are not tracking capital gains or losses within these accounts there is no need to worry about these fees from a tax perspective. That doesn’t mean you shouldn’t pay attention to fees and commissions on trades in these accounts though because it is still important from a standpoint of understanding your real return after expenses.

Also, with commissions as low as they are today this probably doesn’t amount to a whole lot of money for most people. Even though it may not be a large dollar amount it is still important to make sure you are capturing the correct cost basis and also to make sure you aren’t double dipping. I have encountered clients in the past who were getting adjusted net proceeds 1099B forms and on top of that they were itemizing their trading costs which included commissions. This is a great way to grab the attention of the IRS.

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Questions From Readers: Can I Deduct Brokerage Commissions Paid to Trade Stocks For Tax Purposes?

According to this article over at Yahoo 80% of employers are offering bonus incentives this year as opposed to only 51% in 1991. This means a majority of employees will be receiving some sort of additional incentives this year. So are you receiving any sort of bonus this year? If so, what do you plan on spending it on?

The article suggests three areas to target for this windfall:

1. Emergency fund
2. High interest-debt
3. Retirement

This will be my first year receiving a bonus, which couldn’t come at a better time. Even before seeing the list above our plans were to sock a little bit back into savings which recently took a big hit thanks to emergency car repairs. The rest is most certainly going towards debt. That isn’t to say every penny will be used this way as some will be spent on ourselves. I have no idea what it may be yet, but 2006 was a very frugal year for us with very little in the way of “fun” expenses. We deserve to enjoy a little bit of it.

So, I just wanted to ask the readers if they are receiving a bonus and what the plans for that money are. Anyone planning on blowing it all on a new home theater setup? New car? Or is everyone being fairly conservative and paying bills with it?

About the Author: Jeremy is a retirement planning specialist and founder of Generation X Finance and the guide to Financial Planning at About.com. To learn more, follow Jeremy on Twitter.

Question For The Readers: What Are You Doing With Your Year-End Bonus?