Choices

What made it easier to transition to my new status as unemployed?

We lived below our means.  Our lifestyle choices made it easier.   We had taken certain steps years earlier, when we were both starting our careers, that have given us the financial flexibility and ability to deal with this blow.  We have always lived below our means, and so we were not dependent on both of our incomes to make ends meet.

What did it mean to live below our means? 

When I mentioned our lifestyle choices, there are several components and categories.  There are so many choices.  Housing.  Variable expenses.  It's very easy to spend A LOT in Silicon Valley or anywhere for that matter.

• Housing - in Silicon Valley, housing is a major expense.  In certain cities, the average cost of a home can be more than $1 million!  Cities such as Palo Alto, Los Altos and Cupertino have averages that exceed $1 million.  How can an average person afford a house?  Most people I know stretch quite a bit to afford a house.  

• While we bought  a house quite a while ago, housing was still quite expensive.   While we looked at houses in Los Altos and Palo Alto, there just wasn't that much value.  The houses were just too expensive (the cheaper houses didn't have the square footage we wanted, were older and required quite a bit of work) and our monthly mortgage would take up too much of our net income.  After paying the mortgage on these houses, we would barely have enough to cover our other expenses.  It made me think about the housing/mortgage industry and how it does not have our (the consumer) own interests at heart.  Real estate agents want us to buy the most expensive house possible so that they can get a bigger commission.  Mortgage companies say that one could get a mortgage that represents up to 30% of our gross income (they get more interest), but in my opinion, that is much too high.   

• Ultimately, we chose to buy a more modest house.  We ended up looking at houses in more affordable areas like Santa Clara, San Jose and Willow Glen.   I just wasn't comfortable stretching our budget too much to buy a house.  I wanted a mortgage that one income could support.  We made this decision based partly on our other goals:
• Family - we knew that we want to start a family and thus other expenses would need to factored into our plan (childcare expenses, saving for college, etc.).
• Retirement - both of us were conscious of the need to save for the future.
• Standard of living - we weren't really willing to sacrifice too much just to have a house in a certain zip code or have a house that had all of the bells and whistles. One thing that we realized is that real estate taxes are also quite high.  The more expensive the house, the bigger the tax bill. 

 It's a funny thing when I think about housing expenses.  I know a lot of people who had stretch quite a bit to buy a house.  Maybe it was because they wanted to live in a certain school district or maybe they just wanted a big "show" house, but to see their day to day struggle to pay the mortgage (in addition to their other expenses to keep up with their desired living standard) just made me feel as though I made the right decision. 

Funny thing is (or, really not so funny), it's a vicious cycle.  In some ways what makes us want to keep up with the mythical "Joneses"?   Once you live in a certain "prestigious" neighborhood, there is there pressure to keep up appearances.  Once you have a "nice" house, you'll need a "nice" car, and "nice" furniture and then go to the "right" school or preschool or even private school, and it's endless. 

 I think this is the main reason why even with my being laid off, we'll be fine.  By living below our means, it makes it easier to live without both of our incomes.  If we had spent all of the money that was coming in, then we would become dependent on ALL  of our income and any reduction would be a problem.   It would be difficult if not impossible to save.

However, by living below our means, we got used to living on a certain income.   Also, since we had the habit of saving, we have a cushion to lessen the blow.   I realized that there are so many demands on our money.  It's a finite resource and should be respected.  Balance.  That's what's needed.  Balance of wants and needs and a healthy dose of realism.  Yes, I would have loved to live in a really nice house, but was I willing to deal with the sacrifices to live there?  Would I want to deal with the stress to make enough to pay the mortgage month after month after month?  How would I deal with other expenses, such as childcare?  Would I be limiting my options in the future? Would I feel stuck if I had such a huge mortgage?  In the end, there were too many doubts and common sense prevailed.  I still think about the houses that could have been, but I'm so much happier now in my house.  It may be modest, but it's still my home.

We created a habit of saving.  This is part of living below our means.   We have saved and save consistently.  This now gives me great comfort during this uncertain time because now we have a bit of a safety cushion to manage any contingency.

We invested in our future.  We had always saved for our future by putting money into our 401(k) accounts (at least to maximize our employer match and then some). 

We avoided debt.  Don't get me wrong.  We still have credit cards, but we paid them off in full each month.  The interest rates were just ridiculous and if I couldn't afford it, I just waited until I saved enough so that I could pay it off by the time the bill came. 


  

Secrets of Extreme Savers

I was reading the "Secrets of Extreme Savers" article in CNNMoney, and I was struck by the ability of these people to save so much. The main principle was to live below your means and make savings a priority.

The first family profiled, Ed Haskell and Debbie Chasteen, were able to save about 50% of their after tax income. They paid cash for everything (even their house!) I was filled with feelings of awe - they put to practice what most people give lip service to. It seems like they had a goal in mind, to have financial stability so that they can retire early and it definitely takes a lot of discipline to put into practice those goals.

When I started to look more carefully, I realized that most people seemed to live in areas where there is a lower cost of living. In the Bay Area, the cost of living is so high. One who was profiled lived in Los Altos Hills, but then I read that he was a lawyer and I was like, of course they could save so much! He probably makes so much!

I had to catch myself then and not turn into a skeptic and make excuses. It was still amazing that these people made saving priority. Of course, each of the people profiled could have spent what they made or more.

Looking more closely at their profiles, I knew that I had to start thinking about how to adopt the following principles:

• separate wants from needs and really think about each purchase,
• save for each purchase,
• think about multiple streams of income (if possible),
• have a goal in mind, whether it is early retirement or freedom,
• live modestly (or reset expectations), and
• prioritize.

What exactly did I want? Did I want to retire early? Did I want to stay at home with the kids? Did I want to have a large safety cushion just in case? What was my motivation? I had always been a saver, but now I was inspired to do more to ensure my goals would be met.

401(k)

If your employer has a 401(k) plan, it is the easiest way to save money for retirement. It is a way to pay myself first because it is taken out of my paycheck before it is deposited into my checking out.

I think that saving for one's retirement is an important goal. Unless you are lucky enough to work for a company that has a defined benefit pension plan or are independently wealthy, you'll need to save. Hopefully, Social Security will still be around, but I have serious doubts about its solvency and I'll likely be getting very little in terms of benefits, if at all. Even then, I doubt that I could survive on Social Security alone if I'm not able to save anything, so saving something, if only a little bit is a must.

What is a 401(k)

A 401(k) plan is based on IRS code and are employer sponsored. There are two variations: (1) a traditional 401(k) account where money is taken out on a pre-tax basis and income taxes are deferred until withdrawal, and (2) a Roth 401(k) account where money is taken out on a post-tax basis, but withdrawals are tax free.

Benefits and Reasons to Invest

If you're lucky, you work for an employer that encourages 401(k) participation by matching a portion of the contributions that an employer makes. For instance, some employers will match 50% of your contributions up to 6% of your earnings, which is a 3% total contribution. This is free money! At the very least, in this scenario, one should contribute at least 6% of earning in order to maximize the employer match, but some employer contributions are subject to vesting requirements (some have a 4 year vesting period, were 25% of the employer match vests each year).

Another benefit if you invest in a tradition 401(k) is that it defers some of your federal tax liability for the current year. For instance, if you made $50,000 and contributed $5,000 to your traditional 401(k), then you'd only have to recognize $45,000 of income. This may also be a means to lower your tax bracket if you are on the fringe. However, note that withdrawals are taxed. In some sense, you only defer your tax liability but hopefully at that time, you will be in a lower tax bracket so the total tax liability will be less.

Downsides

There are a few downsides to investing in a 401(k):

• Some plans offer a limit set of investment choices. I would still do a bit of research because your contributions are still an investment and it may not make much sense if you have poor choices. Before investing in any fund, I do a basic search on Morningstar and look at each fund's ratings.

• Some have high fees. Look at BrightScope, to get an idea of whether your plan has higher fees than those of its peers. While it looks at outdated data, at least it will give you an idea.

• It's still a bit risky. Notwithstanding the tax benefits and the ease of "investing", it's still an investment subject to risk. Note that this is a long term investment and the stock markets (assuming you invest most of your contributions in stock funds) have generally gone up in the long term, there are still risks involved. Just look at the recent stock crashes. I remember looking at my 401(k) statements in dismay last year when the stock market plunged. It felt as though all of my hard work was all for naught and that I should have just spend the money (however, if I hadn't just kept on going, I would have then missed out on the impressive rebound, but let's see how that lasts).

Withdrawals

401(k)s are supposed to be long term investments. This is supposed to be for one's retirement. Thus, the most important question, really, is when can I withdraw the funds? When I started working, I was 27 and 65 seemed like an eternity away. Was I really going to put money away now so that I can enjoy it 38 years later? In some ways, I knew that I would have to save for my eventual "retirement" but it seemed so distant, so theoretical whereas I had pressing needs that needed immediate attention. Rent/Mortgage. Food. Entertainment.

But, I knew that I wanted to take advantage of the power of compounding and start investing early. I knew that the earlier I started, the better off I'd be so I bit the bullet and started contributing to my 401(k). I have faith that in the long run, the stock market will go up, but even if it didn't, I want to at least have some money put away.

So, when will I be able to start withdrawing money from my 401(k) accounts? At the earliest, when I'm 59 and a half (59 1/2). Any withdrawal before then would be subject to an additional excise tax of 10% on top of the ordinary income taxes, unless there is a exception such as a hardship withdrawal. Hardship withdrawals include payments to cover medical expenses, cover the down payment or to avoid foreclosure on your principal residence or to cover tuition.

To avoid this, you could consider a 401(k) loan, but there are also disadvantages to this approach as well.

Contribution Limits

I believe that the maximum contribution limit for the 2009 and 2010 year is $16,500. Future limits are indexed for inflation, but may increase in increments of $500. Employees who are 50 or over are allowed to contribute more (a "catch up contribution") of up to $5,500, which can also change in the future.

Generally, I think that 401(k)s are a great investment tool to enable a person to save for the future. It is automatic (taken out before I even get my hands on it) and I get free money in the form of my employer match.


Disclaimer: this is not investment advice. This just reflects my own observations and understanding of 401(k) plans.