["Ask a Fool" is a new format we are trying out here in the Foolish Four area. It's a fun way to address the general investing questions our Foolish Four readers have always come to this area for. We'd love for you to submit questions for the column (click the bylines for email), but if you want an actual answer anytime soon, we suggest you pop over to the Ask a Foolish Question discussion board and post there as well. Although we are soliciting questions of general interest to answer here, we can't answer them via email. That's private investing advice, a big no-no. This way, if we screw up, someone will notice, tell us off, and we can print an abject, groveling apology, hopefully before you take our advice and invest in Pets.com.]
Q. Is it wrong to have all my IRA in the Vanguard Index 500 at the age of 39?
A. The last I checked, Moses was never told, "Thou shalt not invest thy entire IRA in the Vanguard Index 500." There are no absolute "right" or "wrong" investing decisions. Except in retrospect, of course. Then it's easy to see which were the best choices. (Hindsight turns everyone into Peter Lynch.)
An index fund is low-maintenance and virtually guarantees that you will outperform most other mutual funds. But, as you say, you are only 39. Assuming you don't plan to retire at 45, you have time to take some risks. The problem with index funds is that they also guarantee that you will never beat the market average, and that can make the difference between a rowboat and a speedboat when you retire.
It sounds like someone has been hinting that your investments are too conservative for your age. They've been reading Money Magazine, I'll bet. You are the only one who can decide what level of risk is right for you and how much time you want to spend on your investments. Hint: Are you asking us to help you justify a decision you are comfortable with, or are you hoping we will encourage you to broaden your horizons? The answer to that question will tell you whether it's right or wrong for you to stick with an index fund.
Q. I know this might sound stupid, but what are "blue-chip stocks"?
A. Not stupid at all! Here at The Motley Fool, the only stupid question is: Why do you guys want to make money?
The companies referred to as "blue chips" are big bruisers that have been around a long time, with solid histories of earnings and dividend payments. They're perceived as being of higher-than-average quality and lower-than-average risk, and include such stalwarts as General Electric <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %>, IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, and J.P. Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %>.
The origin of the term "blue chip" comes from gambling. You figured that, right? It's broker slang of yesteryear. Some old-time brokers must have frequented a casino where the blue chips were the most valuable. By contrast, "red chip" companies are smaller, younger, less proven, less valuable, and usually riskier.
Q. My divorce is imminent and my share of the "pot" will be coming from the retirement funds. What do you suggest I do with them? Pay off the house? Reinvest? Keep them where they are? What are the tax implications?
A. The tax implications are huge, and they're all on your side if you don't touch those funds. If you start pulling the money out, the tax implications are terrible -- for you anyway; Uncle Sam makes out very nicely.
For some reason, IRAs, 401(k)s, Keogh plans, etc. seem to be a huge source of temptation for some folks. That's probably because they don't understand what those withdrawals will cost. Here's the deal:
Let's say you are in the 28% tax bracket. Do you know what you would pay in taxes if you took $25,000 out of your retirement funds? About $9,500 -- plus a few hundred to a few thousand in state taxes unless you live in a no-income-tax state. That's 28% in income taxes, plus a 10% penalty, plus your state rate. Take out $25,000, spend $15,500 or less, send the rest to the IRS.
In the 15% tax bracket, the check to Uncle Sam will be $6,250. And we haven't even touched on what that withdrawal could be worth in 20 years -- close to $250,000, given that you achieve 12% per year.
So, let's assume you've decided not to pay off the mortgage.
What you do with the funds will depend on what your current plan allows. If the money is in your spouse's name in a 401(k) or similar type account, you might be able to keep it there or you might not. That depends on the plan. Whether you are forced to move it, or just have the option, consider rolling it into an IRA. That's a good choice for most people, although it takes a bit more work. Before you decide, though, check with the 401(k) plan administrator about any special goodies, such as loan privileges, you might be giving up. The advantage of rolling the money into an IRA is that you have much more flexibility. You can put the money right back into funds similar to the ones that the 401(k) plan offered, or you can invest in, well, almost any other fund or stock in the world.
Also, check with the plan administrator to see if there are deadlines for converting to an IRA. You might have to make up your mind within 60 days. Don't panic, it's quite easy to open a brokerage account, arrange the transfer, and then just stick the cash into a money market account or index fund until you are sure what you want to do with it. You can take your time on that, but our 13 Steps to Investing Foolishly is a nice place to start.
One other thing: Ask if any of the money in the account right now is after-tax dollars. If you have already paid taxes on some of the money in that account, by all means, have the plan administrator roll that amount separately into a Roth IRA. If you commingle the funds, you will pay unnecessary taxes on part of the money after retirement, but the biggest advantage of separating the funds is that the returns in the Roth IRA will be tax-free upon withdrawal -- as long as you follow the rules.
Good luck.
