Afford Anything - Ask Paula -- Death, Taxes, Crushing Debt and Moving in with Mom

Episode Date: January 2, 2017

#58: Ashley is a single mom saving diligently for her 2-year-old son. What alternatives are there to 529s and brokerage accounts? Julie and her husband invest quarterly. Should she try buying European equities when they are much cheaper due to Brexit? Nicholas and his wife make too much money for a Roth IRA. Should hey do a backdoor Roth? Melissa has money to save, invest, or pay down rentals. What’s her best option?   Find more in the show notes at http://affordanything.com/episode58 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. And that's true, not just for your money, but your time, energy, attention. So what decisions are you going to make about how you spend and optimize those limited resources? Welcome to 2017. This is the first episode of the year. My name is Paula Pant, host of the Afford Anything podcast. Happy New Year. Today is the first Monday of the month.

And you know what that means? It's time for me to answer. questions, questions that you sent in. For those of you listening, if you want to send in a question, just head to afford anything.com slash voicemail. That's afford anything.com forward slash voicemail, where you can also leave a question that will be answered on a future episode. Our first question comes from Ashley. Hey, Paula, I love your show and here's my situation. I'm a single mother of a two-year-old son. every month I save $150 to $200 in a money market for him.

I'm looking to invest this money as it is constantly growing so that the interest will compound and so that he will have a financial nest egg once he becomes of age, whether it be to buy his first car or pay for college tuition or if he decides not to go to college, he may want to become an entrepreneur or purchase his first real estate property. I've looked into some investment options for minors. Most of them I am not fond of. The prepaid tuition and the 529 plan are too restrictive. He may not want to go to college. The brokerage accounts I'm not fond of because I don't feel comfortable with a 20 or 21-year-old having access to tens or hundreds of thousands of dollars that they have not actively worked hard to earn.

So he may not understand or appreciate the value of money at that time. And I would have no say-so over what he did with that money. He does have a savings account in a money market, like I just said earlier. But I want to know, what would you do if you were me in this situation? How would you invest the money for your child? Thank you. Ashley, thanks for asking that question. And that's awesome.

I love that you're doing that for your son. Here's what I would do if I were in your shoes. first of all, even though this money is for your son, I would keep it invested in an account that's in your name. That way, you have total control over how much money you can give to him. I totally agree with what you said in terms of it can be a bad idea for an 18 year old or a 21 year old or a 25 year old to have access to thousands and thousands of dollars that they haven't worked for. That can be a recipe for making a some really bad decisions, especially at that age. So if you keep this money invested in an account that's in your name, you'll have complete control over how much you give to him, when you give it to him, all of that. You control everything. So mentally, you've earmarked it for him, but on paper, it just looks like an account that's for you. Now, I would put this, if it were me, I would put this in a Vanguard Target Date retirement account. And I'd

I would just set that target date to, depending on how old your son is right now, 10 years, 15 years, 20 years into the future. So if your son is five and you want this money to become available to him when he's, you mentioned buying a car, so maybe 15 or 16, I'd just put it in a target date 2025 fund or a target date 2030 fund. And when you give him this money, you are allowed to give him up to $14,000 per year tax free. This is called the gift tax exclusion. And as of the year 2016, an individual can give another individual $14,000 a year without the recipient paying any taxes on that. So you'll be pretty well covered for giving a tax-free gift. So that's what I would do if I were in your shoes. Now, that being said, there is a little bit of risk.

Of course, all investments have risk. The important thing to remember about Target Date funds is that they are designed. for people who are retiring in that given year. When a person retires, they don't withdraw all of their money, their full portfolio that year, right? So if you retire at the age of 65, you're not going to withdraw all of your investments and put them all in cash. You'll only withdraw maybe 4% of your portfolio. And so that's the one risk or the one drawback of using a target date fund in a way that it's not designed to be used is that your investments will be optimized for a different situation and therefore they'll be exposed to a higher level of risk. Like, you know,

if you want to withdraw all of that money in the year 2025, well, the target date fund isn't built for that. There are a couple of ways that you can work around that. Number one, you could choose a target date fund that's much closer to today's date. So you could choose, for example, a Target Date 2015 fund, which is designed for people who already retired a couple of years ago. That's one possible workaround. The other option is that you yourself can split up the money into bond funds, a little bit of equities, and maybe a couple of Treasury, inflation-protected securities. Those are basically the underlying holdings within the Vanguard Target Date funds, particularly the closer timeline funds. So you can make that same type of

portfolio yourself. It's just a little bit more work. Normally, I don't recommend target date funds because most brokerages charge you a premium and you can assemble a DIY package cheaper yourself. But Vanguard is the exception. Vanguard actually doesn't charge a premium for theirs. So the way I see it, if you buy into a target date fund, they'll do the work of keeping your equities and bonds and securities balanced. And they'll do that work for. you for no additional fee. So that's the reason that I would go with a fund from them, but not necessarily fund from many other brokerages. I think you're making a fantastic decision and thank you so much for calling in with a question. Thanks, Ashley. Our next question also comes from Ashley and it's a

great one. Hey, Paula. I have a question. I have two major debts that I want to pay off within the next three to five years. One major debt being my mortgage, which I owe $62,000 on my home and my student loans in which I owe $56,000. So thinking outside of the box, I had this great idea that I could move in with my mother and rent my home out as my first rental property, which is something I'm also wanting to get into. With the additional income that I would have, I could either pay extra on my mortgage or I could pay additional payments to my principal for my student loans. So I'm just kind of weighing the options to determine if this makes sense or not. My home I purchased six years ago. It was a foreclosure. I paid $68,000 for it and $3,000 in closing costs. My mortgage payment does

include taxes and fees and my homeowner's insurance. I pay $100 in $100 in. HOA fees. My home appraises at about $91,000. So it looks like I should be able to rent my home out for about $100, I'm sorry, rent my home for about $900 a month if I am calculating the 1% rule correctly. What do you think? Awesome. I love this idea. So Ashley, the first question that I would ask you is could you stand living with your mother? And I mean, I'm being completely serious here. Would you be able to actually maintain your sanity while living with your mom. If the answer is yes, and you are serious about that, if you really think that that's something you could do, I think this is a great opportunity for you to just pay down either

the mortgage or the student loan, pay down either one of those or both of those debts, and really fast track your way to debt freedom and eventually financial independence. So yeah, if you can maintain your money. your sanity while living with your mom, do it. I'm jealous. Now, a couple of things. I'm assuming that your home meets the 1% rule. It may or may not. The best way to figure out what it would rent for is to search your neighborhood as though you were a renter. So go on Craigslist or Zillow or Trulia or Redfin, get on any of those websites and run a search from the point of view of somebody who wanted to rent a home like yours in your neighborhood. So for example, if you have a three-bedroom,

two-bath, single-family home, then search for three-bed, two-bath, single-family homes in your zip code or in the name of your neighborhood. And just by doing that, by running that search, you'll be able to see what other options are out there, how much those options cost, how nice those houses are. You know, you'll basically be able to see the competition and you'll see exactly what your renter is going to see when they're looking. So that'll give you a good idea of how much to price the rent for. Another option that you have is if you're not sure if you're going to be able to stand living with your mom for a year, you could always try it, sign a renter to a six-month lease, and then see what happens, see if you like it. The last thing I'd say is before you put your house up

for rent, actually two more things. Number one is take excellent photos of this property. Good quality photos can actually give you the opportunity to rent your house for more money than you otherwise would get and or to rent it out faster to find a tenant faster than you otherwise would have. Because when people, when renters are looking at listings, they look at the photos first. They only bother reading the listing if the photos strike them, and particularly if the photos really strike them emotionally. So open all of the windows, open all the window blinds, bring as much natural light into the house as you can, take the photos at the peak of daytime, you know, when you've got maximum sunlight, and put a little bit of staging into your photos. What I mean by

that is if you are photographing a bedroom, for example, make sure it's clean, make sure the bed is made, nicely made, and stage it, you know, to make it look a little more Pinterest-friendly, basically. Put a nice vase of flowers on the bedroom table. Put some extra pillow, on the bed, you know, little touches like that that make it really stand out with your bathroom. You know, when you take those photos, have maybe a pile of towels that are all the same color that are piled neatly folded on the bathroom vanity with maybe like a tiny little soap on top. Basically, the kind of stuff that you see on Pinterest, do that because most landlords don't. And when you look at most listing photos, none of that's there. And so those touches can really make your listing stand out. So that's one more piece of advice that I would give. And then the final thing that I would say is that before you rent it out, think about what criteria you want the tenants to meet. So what income do you want them to have? What credit score do you want them to have? And what type of rental history do you want them to have? Decide what you want your criteria to be before you start.

receiving applications. Because once you start getting those applications, it's easy to talk yourself into accepting a tenant because, you know, a bird in the hand is worth two in the bush, right? You've got this application in hand. They're willing to move in in a week. And you don't want to say no to that. So it's much easier to stay objective if you've already decided on what your deal breakers are going to be before you start advertising for a tenant. I guess in that regard, it's a little bit like dating. Like you want to decide what your deal breakers are before you go out there and start dating and searching the pool.

Otherwise, you might end up with a complete dud. So same deal with tenants. Decide what your deal breakers are. And for example, you might decide that their income needs to be three times the rent. Or you might decide that their credit score needs to be above 600. I'm not saying that that's what your criteria should be. Those are just examples. and you need to decide what you want for yourself.

But know that in advance and write it down so that you can't talk yourself into accepting somebody who doesn't meet your standards. Thank you so much for asking that question. Our next two questions come from Vanessa. Hi, Paula. This is Vanessa from Brooklyn, New York. I'll leave two messages because I have different questions.

So I'm in the process of paying off debt. One card card right now, $770 balance, $2,500 limit, $1,700 balance on another one, $3,500 limit, two personal loans about $2,000 each, and my student loans, $7,700, all the loans are in a monthly plan, the credit cards. I'm attacking the smallest one right now, doing the minimum on the other. My question is, I'm thinking of either closing out one of the credit cards once they're paid off or maybe possibly closing out both. I'm wondering what you would advise. Both of them I've had since college. I'm 39 years old, but the interest rate on the cards,

both of them are terrible. One, I think it's about 15% last time I checked. The other one is like a little bit higher at like 17 or so. As I said, I've had them a long time since college, but I would not mind getting a new card with a new company or if they could possibly maybe

if I could contact them and maybe get them to reduce that interest rate. So what do you think would be a wise way to do this? What would you recommend? So let me know. Thanks. Vanessa, first of all, congratulations on being committed to paying off your debt. You've mentioned that you're paying off the smallest balance, getting rid of that, and then snowballing your way through all of the other debts. So I love that you're actively improving your financial life. So awesome, good for you. As far as whether or not you should close out that credit card account, I would say no and here's why. You're 39 years old and you've had this since college, which means that, The length of your account history is quite long.

You've had this card for approximately 20 years. Now, your credit score is comprised of five factors. Number one is your payment history. Even just one single late payment can damage your score and then also the longer that you're overdue, 30 days, 60 days, 90 days, 120 days, the worse it gets. So that payment history is 35% of your credit score. 30% of your credit score is the amount owed relative to the amount that you can borrow. This is known as your debt utilization ratio. It's how much you owe relative to your total limit.

So for example, if the credit limit on one of your credit cards is $10,000 and you currently owe $2,000 on that card, then you're utilizing 20% of your limit. ideally you want to stay at about definitely less than 30% of your limit and ideally even 10% or less. Now, here's the catch when it comes to the amounts owed. And I realize I'm straying a little bit far from your question, but I promise we'll get back to there. I just want to establish how your credit score is determined because I think that's an important foundational piece of this answer. So here's the catch. Your debt utilization ratio is measured by the amount that you charge. even if you pay that bill in full every month.

So hypothetically, if you were completely debt-free and you paid zero in interest and you use your credit card just as a proxy for cash and you pay the whole credit card off in full every month, even in that situation, you could still have a damaging utilization ratio. And that's often why I advise people that if you're going to use your credit card to make a big purchase, pay the card off in full that same day. Like if you're going to buy airline tickets, for example, and use your credit card to make that payment, that day or maybe two or three days later when the charge posts to your account, log in and pay it off immediately so that you can keep your utilization ratio low. If I know that I'm about to take out a mortgage or refinance a mortgage, I'll get into the habit of just paying off my credit cards in full once a week, every week, just to keep my utilization ratio low. low. So anyway, TLDR, the bulk of your credit score is determined 35% by your payment history,

whether or not you pay on time, and 30% by the amount that you owe on your cards relative to the amount that you can borrow. However, there are three more factors that influence your credit score. One of those three factors is the length of your credit history. And what that means is the older your accounts, the better. If you have a handful of accounts that are in good standing that you've had for 20 years, these accounts allow you to have a longer credit history. They skew the average age of your account into a more impressive number. So if you've got these accounts that are 20 years old, you have a very long credit history and the length of your credit history comprises another 15% of your credit score. And that is the reason

that I recommend not canceling your cards. Now really quickly, I'll just go through the other two factors that influence your credit score, and then I'll get back to what I do recommend that you do with those cards. Really quickly, the other two factors that influence your credit score are the number of credit inquiries that you have. So every time that you apply for new credit, your score gets dinged. That comprises 10% of your score. And then the mix of the type of accounts that you have, whether you have revolving credit, such as credit cards or home equity lines of credit, or whether you have installment credit, which is the type of credit in which you pay fixed regular installments, such as a mortgage or an auto loan. That account mix comprises another 10% of your credit score. So combined the types of accounts

you have, the number of credit inquiries, the length of your credit history, the amount that you owe or slash amount that you charge your debt utilization ratio, and your payment history. Those are the five factors that influence your credit score. You do not, and this is important, A bit of a tangent, but this is like a personal pet peeve of mine, you do not improve your credit score by carrying a balance. A lot of people mistakenly believe that that is the case. And so a lot of people will mistakenly intentionally carry a balance in the hopes that that will allow them to improve their score. No need to do that. Now, what will help you improve your credit score is keeping those two 20-year-old credit card accounts open. But given that you don't like those accounts,

What I recommend is keep them open, but don't use them. So in other words, behave as if you've closed the account, even though technically the account is still open. Cut up those credit cards, grab a pair of scissors, chop them up, chop up the cards into a million little pieces, set them on fire, throw them in ice, throw the ice in a jar of peanut butter, set the jar of peanut butter on fire, call the fire department because you're lighting a lot of fires at this point. just completely obliterate the cards themselves, but technically keep the account open. And if you want to take it to the next level, if you just want like a stopgat measure, the other thing that you can do is put one of those identity theft, identity verification locks on your credit so that nobody can use that credit account or apply for a new line of credit without you personally being informed of it. You don't have, I personally don't do that, but I know several people who do if they keep old accounts open, then they'll put some identity theft protection on it just to be on the safe side.

So that's what I would recommend that you do. And that solution will allow you to maintain your long credit history while at the same time not using shi-cddy cards that you don't want to be using. So thanks again, Vanessa, for asking that question. And by the way, in the show notes, I'll link to an article that explains how your credit cards. its score is determined and how it's broken down. So that will be in the show notes at afford anything.com slash episode 58. Again, that's afford anything.com slash episode 5.8. All right, Vanessa, you ask the next question as well. Let's have a listen. Hi, Paula. Vanessa again from Brooklyn, New York. My second question, right now I'm single,

no children. So my nieces and nephews are my beneficiaries on most of my financial products. I had a question. Inherited IRA. I'm very confused as far as what my, right now my niece is, one of my nieces is the beneficiary on my IRA. I'm confused as to what her options would be once she inherits the IRA, any possible tax consequences for her. As I said, I tried to read up on it, but I got so confused. So if you could maybe explain that in a bit more detail, I'm trying to see if maybe I might you know, restructure some things so that later on, not that it would be easier for her, but, you know, depending on how I got actually very confused with since she's not, you know, a spouse and she's, you know, a family, well, not a spouse, not a child, that the options she has are different, you know,

if I had a spouse or something, it would be a bit easier, I guess, more options, I believe. Well, as you can see, I'm very confused with the inherited IRA. But yes, if you could possibly go over that inherited IRA, what are the options for the person that's inheriting that is not a spouse or a child? Thanks. Hey, Vanessa, this is a great question. You're right. The world of inherited IRAs gets a little bit complicated, but here is the answer. When you pass away, your niece, the person who is inheriting this IRA, will have three choices.

Number one, your niece can transfer this money to an account that is known as an inherited IRA. So basically, in your lifetime, you have this money in an IRA. Upon your death, this money, this IRA gets transferred to your niece as the beneficiary. And then your niece can open an account that is called an inherited IRA. And the money that is inside of this inherited IRA will continue to grow, tax deferred. Your niece will also, generally speaking, be able to withdraw this money at any time without penalty. So even if your niece inherits the money when she is 20 years old or 25 years old, you know, she doesn't need to be at typical retirement age, at standard retirement age, your niece can withdraw money from the IRA, from the inherited IRA at any time without penalty. Or if she chooses, she can let the money stay in the inherited IRA and let it continue to grow. She will be required to start taking required minimum distributions or RMDs.

The RMDs are the primary, quote unquote, burden with the inherited IRA account set up. Now, if she wants to take money out of the IRA and she has the option to take all of the money now, that money will either be pre-tax or post-tax depending on what type of IRA you've opened up. So depending on whether it's a traditional IRA in which you contribute pre-tax dollars or a Roth IRA in which you contribute after-tax dollars, that's going to affect the taxes that she pays. And depending on how much money is in there, it may or may not push her into a higher tax bracket. But that's true really of any investment that she withdraws. I mean, if you sell a house and you don't do a 1031 exchange on it, or if you withdraw money from investments that you own, or if you have a job, like any time that you access money, it is typically a taxable event. So the benefit of having this money in an IRA is that while you are alive, this money is growing tax deferred. And then once it passes to her, the amount that she keeps in there is tax deferred. So you're not really creating any. special or unique tax burden on her. And that's basically a long and convoluted way of saying an IRA is a great way to pass money to a beneficiary. So those are two out of her three choices.

She can choose to transfer the money into an inherited IRA that she maintains, or she can choose to take all the money now, take it in a single lump sum payment. Her third choice actually is not to take the money. That is an option that's available to beneficiaries. It's unlikely that she or any beneficiary would take that option. But if she is in a tax situation where she really does not want to take the money, she does have the choice of what's called disclaiming the account. And what that means is that that account would then pass to an alternate beneficiary. It's unlikely that she's going to exercise that option, but worse comes to worse, that's always a choice for her. So I hope that answered your question. But basically, long story,

short, if she gets a traditional IRA, if she gets an IRA in which you've contributed pre-tax dollars, then she will have to pay taxes on the money that she withdraws from this IRA. But that's true of any traditional retirement account, whether it's one she inherits or one that she sets up herself. And if the IRA that you provide is in a Roth account, then your niece, the beneficiary, will have to take RMDs. And those RMDs are going to be based on the year of the original account holder's death. So those RMDs, unfortunately, aren't going to be based necessarily on your niece's age. They'll be based on a timeline that's determined by when you pass away. This is a very gruesome conversation. So the drawback to a Roth account is that

the money can't continue to just grow tax deferred for a very, very long time. But the benefit, of course is that the beneficiary can access those earnings tax-free. And that's another way of saying that there are pros and cons to both a traditional and a Roth IRA when it comes to inheritance. So don't feel like one is necessarily better or worse than the other. They both have their pros and cons. By the way, I am going to link in the show notes to a PDF that does a pretty good job of explaining the tax implications of inherited IRAs. So that's going to be available in the show notes at Affordainthing.com slash episode 5-8. Thank you so much for asking that question, Vanessa. Hey, hey, we'll be back to the show in a second, but first, I want to give a shout out to Fresh Books.

They have signed on as one of our main sponsors in 2017, and they have an awesome product. It's meant for freelancers, solopreneurs, small business owners. If you, you're If you have a side hustle or if you're self-employed and you need to send out invoices to your clients, yeah, it's necessary. You've got to send invoices to get paid, but it's also annoying and it's time-consuming and nobody really likes doing it. It's just one of those costs of doing the job. Inter Fresh Books. They automate the invoicing system. You type in some basic information and their system handles the rest.

It automatically sends follow-ups to invoices that haven't gotten paid. It lets you know whether or not your client has even open to. your invoice or not. Basically, they take the suckiness out of invoicing. Give them a try for free for 30 days at freshbooks.com slash paula. That's freshbooks.com slash p-a-u-l-a. Our next question comes from Julie. Hi, Paula. This is Julie. I have a question about asset allocation and market timing. My husband and I invest a certain amount of money each year, which we save up monthly, and then transfer and invest quarterly. And I do this based on a plan that I create the previous January to rebalance our portfolio. You don't sell anything.

We just use the new contributions to rebalance. And our target allocation are fairly wide ranges. Say European equities are not 30%, but 25 to 35%. And we're 20 to 25 years away from retirement, so we feel comfortable with that kind of flexibility. So my question is, if say this quarter I have planned to invest in U.S. equities, but they've gone up dramatically since January, while European equities, because of something like Brexit, have decreased. So am I being smart in changing my plan and buying European equities when they're on sale, and I believe they'll eventually recover? Or am I just practicing market timing and then

trying to rationalize this decision by thinking, well, as long as I'm in that range that I'm comfortable with, it should be okay. What do you think about this? Julie, it sounds like you're being smart about it. And here's why I say that. It sounds to me, and correct me if I'm wrong, but it sounds to me as though you already know what you want your desired asset allocation to be. And the example range that you gave me was, you know, only a 10% spread between X and Y. You know, so, for example, you might want between 25 to 35% in European equities, maybe another, I'm just going to make up some. percentages here, maybe another between 15 to 20 percent in other types of non-European international

equities. And then you have somewhere between 40 to 55 percent leftover that gets split between U.S. equities and bonds, for example. So if that is the asset allocation that you and your husband have always been aiming for, if that's a path that you chose before Brexit and before all of this turmoil that started happening in Europe, then it sounds to me, in that case, it sounds to me like you're staying the course. To say that a different way, it's perfectly fine to have an asset allocation that's expressed in percentage ranges, as long as those percentage ranges are not too wide. So, for example, I wouldn't encourage you to say, like, well, I'll have somewhere between 10% to 30% of this given asset class. You know, that, okay,

That's a little bit wide. But if we're talking about a range that's, you know, a 5% difference, 10% at most, I think that's totally okay. And also the fact that you rebalance by buying more rather than selling off some of your current holdings, I think is also totally okay. I mean, the contributions that you make need to be sufficient. They need to be adequate enough to be able to actually achieve that rebalancing. but assuming that you can do that, assuming you can hold those percentages in check, then, hey, why bother selling off your holdings? I mean, what matters is that you have a balanced portfolio. And if you can do that by making new contributions, then awesome, more power to you. Now, there is one thing that you said that kind of concerns me, and that is that you indicated, and this might have just been a hypothetical, but you indicated a pretty strong allocation that's specific to European equities. You said 25 to 35% in European equities.

That's a very high percentage to dedicate towards one continent. Now, I'm assuming that you and your husband live in the United States. You earn money in U.S. dollars. You spend most of your money in U.S. dollars, and you plan on retiring predominantly in the U.S. So your fate is highly tied to the strength of the U.S. dollar. and anytime that you invest internationally, in addition to all of the normal risks that you experience any time you're investing in equities, you also experience the currency fluctuation risk. That's not to discourage you from investing internationally. It's just to say that

there is added risk when you do so. There's currency fluctuation risk. There are differences in accounting structures and the way that corporations in different nations do their accounting. those are all just piled on. And that being said, I think that having an international allocation is great, but I wouldn't necessarily concentrate so much of it in Europe, particularly if you're not earning money in euros or in British pounds, you know, particularly if you have this currency fluctuation issue as well. 25 to 35% is, I think, a pretty healthy allocation for total international,

which would include Asia, would include Latin America, would include Canada and Australia, frontier markets such as parts of Africa, Ghana, Kenya, Botswana, those are all markets that should have, if you are going to have an international allocation, I think you want to spread it around a little bit more. So that's the only part of your question that really raised a red flag for me when I heard it. Otherwise, it sounds like what you're doing is great, and you seem to be totally on it. So congratulations for being so on top of things and for having such a strong, portfolio that sounds like it's going to do well in the long run. Thank you, Julie, and congratulations

on everything you've built. Our next question comes from Nicholas. Hi, Paula. I feel strange for having to even ask this. It's like I'm bragging or something, I guess. My question is, my wife and I make too much to input into a Roth IRA. Should I continue putting money aside in index funds, looking for that 7% return, or should we do the backdoor Roth conversion from a traditional IRA? I know the big gain is taxes, but is a Roth going to really beat 7%? How do I compare if it's worth it? Thanks and keep up a great work. Nicholas, first of all, congratulations on having that problem.

That's a fantastic problem to have. And second of all, my answer is do both. When you do a back-to-a-roth conversion, this is how it works, you put money into a traditional IRA. And so in 2017, that amount is $5,500. You'd put $5,500 into a traditional IRA, and then you call your brokerage and you have them execute a conversion from that traditional IRA into a Roth. Now, here's the catch. You cannot convert the entire $5,500 unless you have no other pre-tax IRA assets. If you do have pre-tax IRA assets, then you have to convert a pro-taxed. rate a share of all traditional IRA dollars into a Roth IRA. So if you have a SEP IRA or a simple IRA,

any type of pre-tax IRA, then you have to calculate a conversion amount that reflects the pro-Rata share of your trad IRA dollars. And in order to do that, you're going to need an accountant to make that calculation. In the show notes, I'm going to link to an article that describes this in a lot of detail. Now, bear in mind, the limits that are in this article apply to the year 2011, so don't pay attention to the actual contribution limits. Just pay attention to the process that they outline in terms of calculating the percentage of your non-deductible IRA contribution that you can then convert into a backdoor Roth. But that being said, all of that put aside, let's go back to your original question. And the way that you phrase the original question, I want to speak to that because what you asked was, can a Roth really beat 7% in an index fund?

That's not an applicable question. So let me address that. A Roth IRA or a Trad IRA or a 401K or a 403B or a simple IRA or a SEP IRA, these are types of accounts. These are not the investments that are within those accounts. So think of those accounts as coffee mugs, right? A Roth IRA is a coffee mug, a Trad IRA is a coffee mug, a 401K is a coffee mug. All of those are mugs, whereas your holdings, your index funds, are the investments contained within those mugs. The index fund is the coffee and the IRA is the mug. So the question that you asked,

which was can a Roth IRA beat an index fund, is not applicable for the same reason that coffee is not the same thing as a coffee mug. One is the holder and the other is the substance inside of that holder. So what I would encourage you to do is based on your income, you're not eligible to make a deductible contribution to a TRAD IRA because that contribution limit phases out even below the Roth phase out. So you're not eligible to make a deductible contribution to a TRAD IRA and you're also not eligible to contribute directly to a Roth IRA. So when you are searching for a tax-advantaged account that you can put your money into, well, a backdoor Roth conversion might be one of your best options for creating that account for essentially buying a coffee mug. And then once you've

bought that coffee mug, fill it up with index funds because index funds are fantastic. They're low fee. over the long term, they historically have made great returns, 7%, 8%, 9%. So set up the coffee mug, which is your backdoor Roth conversion, and then fill it with coffee. Thanks for asking that question, Nicholas. And congratulations on, number one, having the earnings to have this issue because, you're in a great spot for needing to ask this. And congratulations also on being a high-income person who is attentive to. to your investments and attentive to savings because that is the fast track to financial independence. Our final question for this episode comes from Melissa.

Good morning from Colorado, Paula. Well, I guess you don't know what's warning here, but it is. In your opinion, where would you suggest that I would get the best bang for my buck amongst my already existing options, which are maxing out a matching 403B, which is 20% up to 10K, determinable at the fiscal year end, but it's happened every year since 2008, a Vanguard Total Market Index Fund, a Roth IRA, paying down the mortgages on two rental properties I have, or saving for another rental property. If it's helpful, some additional information is that my desired goal is to replace my salary to income, either 50% or 100%, like you did, in the next three or four years. I'm 32 years old, earning a nonprofit salary in the 25% tax bracket.

Real estate is my preferred investment strategy. So there you go. Keep it up. You are stellar. You know that we all love you. Thanks. Aw, thanks, Melissa. If your goal is to replace part of your income or all of your income within the next

few years, real estate is one of the best ways to do that, in my opinion. Rental real estate will produce cash flow. it will produce dividends at a level that you just can't typically get from index funds. One of the questions that I often get when the issue of rental properties comes up, as you may know, I tend to focus on the cap rate that a rental property produces. And the cap rate is the unleveraged net cash return on a property. So, for example, if you pay, I'm just hypothetically pulling numbers here, you pay $200,000 for a property and it rents for $2,000 a month and your operating expenses are

a thousand a month. And so the other $1,000 per month is your net operating income at full occupancy, then that net operating income is $12,000 per year on an investment on a house that is worth $200,000. And that produces a 6% cap rate. So that cap rate, in other words, that 6% what that represents is that the value of the house is $200,000 and your unleveraged net operating income is $12,000. So that unleveraged net operating income is 6% of the value of the property. Now, the reason that I always emphasize cap rate is because this equation, unlike some of the other popular equations that are used by rental property investors, this equation doesn't look at how much money you've borrowed to put into a property. So there's some other equations

like cash on cash return that do. And those equations will unfairly malign the math such that borrowing more leads to better returns, whereas paying cash leads to worse returns. That's the problem with the cash on cash return formula. Anyway, that's a bit of a tangent. But long story short, that's the reason that I always emphasize looking at the cap rate of a property. Now, the thing about cap rate is that cap rate is only one way in which a property gives you returns. Like the cap rate, that 6% that you're getting on a $200,000 house, that's analogous to a dividend on a stock. So it's not that the total return is 6%. It's that the dividend that house is paying you is 6%. And then in addition to that dividend, the house itself is appreciating

in value at, let's just say, the rate of inflation, nothing more. And on top of that, you're also paying off part of the principal balance on that mortgage. You're also building equity from the rent payments of all of the tenants. And so all of that put together produces the total return. And that is a really long way of answering your question. Sorry, I went off on my pro cap rate tangent there for a minute. But that's a very long way of answering your question, which is to say that the total returns that you can get on a property are awesome if you buy the right property and that the cap rate on a property, which could be a 6% cap rate, a 7% cap rate, an 8% cap rate. You know, that cap rate is analogous to getting a dividend on a stock.

And typically, if you invest in index funds, you're not going to find stable blue chip companies that pay 60. to 8% dividends, cash dividends. And that is why, it's a very long answer. I'm sorry, I really went off the rails here, but that is why rental properties are so powerful in helping you reach financial independence. So if your goal, as you've stated, your goal is to replace part or all of your income, high dividend investments, such as rental properties, are one of the best ways to do that. So I would say that the two best options of the options that you recommended, the two best ones that I heard, in my opinion, just in terms of what I would do if I were in your shoes, one is save up for the down payment on another rental property. I think that's a fantastic option. And the other one is to at least get your employer match. I'm a huge fan of employer matches because that's just a risk-free investment. You know, you know that if you put $10,000 into your 403B, you will get $2,000 in return. It's the closest thing to a free lunch in the world of investing that you could ever get. And that's why I'm such a proponent of those. So that's what I would do. I would get your full employer match in your 403B account. And then I would save up the rest of your money to make a down payment on another rental property. Thank you so much for asking that

question. And in the show notes, again, I will link to an article about how to calculate cap rate just because I realized I just spewed a whole lot of numbers in audio form, which is never a good time. Thanks again for listening to this show. I really appreciate everyone of you who have submitted questions. If you have a question that you would like answered on an upcoming episode, had to afford anything.com slash voicemail. That's affordanithing.com forward slash voicemail, which is where you can leave a message. that I will answer on an upcoming episode. There are several of you who did ask questions that we just didn't have time to get to in today's episode.

We will get to those in the February episode. We do these Q&A episodes on the first Monday of every month. My name is Paula Pant. Thank you so much for tuning in to this episode of Ask Paula, January 2017 edition. If you like this show, please do me a favor. Head to iTunes, subscribe to this podcast. and while you're there, leave us a review and upvote some of the other reviews that you really like or that you think are helpful.

Thanks again, and I'll catch you next week.