The sale on emerging markets is even better. Vanguard Emerging Markets Index Fund (VEIEX or VWO) is marked down by 24% in the last 3 months.

As usual, because I’m now low on international funds, I got myself some good treats from this sale. I hope there are bigger sales in the fall and the Christmas shopping season.

• Stories from Strapped: College Education
• Stories from Strapped: Paycheck
• Stories from Strapped: Debt
• Stories from Strapped: Housing

Chapter 5 in Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead by Tamara Draut is And Baby Makes Broke. Basically the author says the younger generation can’t get ahead because child care costs too much.

For a change, I’m going to keep my comments to the minimum this time. I will present the stories and give you a chance to chime in. The first story:

After Renee had her baby son Ben, she and her husband divorced. Her employer only gave her unpaid maternity leave. She got help from welfare, food stamps, and WIC. For one reason or another, the family child care providers Renee found didn’t work out as well as she liked. After a raise and a state budget cut, she lost some child care subsidy from the state. She’d like to put Ben in a formal child care center, but she can’t afford the price.

Next story:

Robin and Jack (from the last chapter) send their son David to a Montessori child care center which costs them $1,300 a month. The center has two teachers for every four children. Because there is high demand for good quality child care, they had to wait a long time before a slot opened up for their son.

Now we know why a couple making $160,000 a year live paycheck to paycheck when they have a $2,500/month mortgage payment. The third story:

Carolyn and Ryan, a teacher and a police officer, were happy with their child care provider until Carolyn got a new job at the opposite end of the town. They visited many child care centers but none met their requirements. When their older son reached three, they also had a hard time finding a good preschool they liked. They finally found one but it cost them total $1,280 a month for preschool for one son and toddler care for another. They had to cut back their retirement savings in order to afford it.

Ms. Draut recommends that the federal and state governments provide paid parental leave for 6 months and universal child care for age 0-5. That sounds good if nobody has to pay but everybody knows that’s not possible. So I have a question. If the younger generation as a whole will receive a net benefit of paid parental leave and age 0-5 child care, that only means the two older generations above them will have to pay because money doesn’t grow on trees. At the same time, the younger generation is paying Social Security and Medicare tax which goes to the older generations’ retirement and post-retirement health care. Shouldn’t we just cut the Social Security and Medicare tax rates and call it even?

Life would be a lot simpler if money were of no object. Then we would all be able to get what we want. What is the proper role of government, if we decide we are not going down the path of "from each according to his ability, to each according to his needs"?

Microsoft has done a very good job for its cashback program. Rebate sites like FatWallet and eBates have been in business for a long time by Internet standard. These sites are paid when you make a purchase through a special link to their affiliated merchants. The rebate sites then share with the users a part of the affiliate payments they receive from the merchants. Microsoft’s program operates under a similar model, but Microsoft has gone a few steps beyond what other rebate sites have done.

1. Immediate rebate confirmation . After you make a purchase, the rebate amount is confirmed immediately, within seconds or minutes. This may depend on how the merchant reports the sale to Microsoft but the technology is there if the merchant chooses to use it. I was able to see my rebate in my Live Search cashback account right away.

When I used FatWallet, the cashback eligibility is usually confirmed only after a few days. In several occasions I used the affiliate link but I didn’t get my rebate at all. Instant feedback increases the user’s confidence in the system. If I shop at my favorite online stores Newegg or Zappos again, I will definitely use Microsoft’s links instead of FatWallet’s.

2. Extra Cashback . Because Microsoft is interested in increasing its market share in Internet search, it’s able to promote its search with additional cashback out of its own pocket, beyond what the merchants pay them. Microsoft can afford to run the cashback program at a loss because it accrues other benefits when people use its search more and use Google and Yahoo! less. During the current back-to-school Live Search cashback promotion, the cashback from Zappos is 18% on Live Search, only 6% on both FatWallet and eBates. The cashback from Newegg is 5.5% on Live Search, only 1% on both FatWallet and eBates. Typically rebate sites share the affiliate payments with the users 50/50. Microsoft not only gave up 100% of the affiliate payments from the merchants but it also put additional cashback on the table with its own money. There’s no way the other rebate sites can match that.

I love it when there is competition. Will Google match or beat what Microsoft does in its Live Search cashback program? Let the cashback war begin!

• Stories from Strapped: College Education
• Stories from Strapped: Paycheck
• Stories from Strapped: Debt

Chapter 4 in Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead by Tamara Draut is The High Cost of Putting a Roof Over Your Head. No need to explain. The author says the younger generation can’t get ahead because housing is too expensive. I’m only interested in the stories.

Lori earns $97,000 a year but she still can’t afford to buy a home because she lives in a big city.

Ricardo and Salina, both immigrants from Mexico 18 years ago, can’t afford to buy a home either. They live in Bronx.

Irene, 33, returned to her parent’s home. She and her ex-husband Adam used to live in a studio apartment in Manhattan, paying $1,900 a month in rent. They could afford the rent because Adam worked in corporate law. She earned $54,000. They lived paycheck to paycheck and wedding expenses added to the financial strain. Adam kicked her out after they had an argument. She couldn’t afford to live in New York city on her own salary.

The author Ms. Draut didn’t say exactly where Lori lives but she mentioned Boston, San Francisco, Los Angeles, New York, and Washington, D.C. as expensive big cities. Is this Lori the same Lori in Manhattan from the last chapter who has $40,000 in student loan debt? $97,000 a year even in Manhattan isn’t too bad, is it? Some people like big cities. Some prefer smaller towns. Income and living expenses are different. Lifestyles are different. We can’t expect to earn a coastal big city salary and pay Midwest small town housing prices, can we? I don’t know what we are supposed to do to address this housing affordability problem. Put in price control like rent control in some cities? Housing prices don’t exist in a vacuum. They are high because other people are paying those high prices. They are your competition. You either have to compete with them head-on or refuse to play the same game with them. Rent, buy less desirable home, or go somewhere else.

The next story:

After working in San Francisco on a $41,000 a year salary as a teacher and paying $1,050 a month in rent, Tony moved to San Diego. His salary is lower, at $36,000 a year, but the rent is lower too, at $700 a month. It’s a little better but he still lived paycheck to paycheck. He had to borrow money from his parents five times in the last two years, usually for weddings and car repairs. He will have to find a girlfriend if he wants to buy a condo.

There we see weddings again. Perhaps it has become socially unacceptable if members of our 18-to-34 generation don’t attend their friends’ weddings even if they live thousands of miles away. Or perhaps our author Ms. Draut is really a fan of weddings. Going to weddings is perfectly fine. It’s all a matter of priority. I don’t see a problem with not being able to buy a condo on one income either. Is every single person expecting to buy a condo? Where does that expectation come from?

Another story:

Nancy and Ed earn $46,000 a year in a suburb near Cleveland. They pay $730 a month for rent. Their other big expenses were their car payments, which cost $700 a month. They drive a 2004 Chevy Cavalier and a 2003 Dodge Sebring (the book was written in 2005). They’d like to save $15,000 to $20,000 for a house down payment but they only saved $1,000 so far. Nancy explains why they are so far away from their goal — "Every time we try to put money in the bank to save, there’s no extra to put away. By the time we get done paying the bills, there’s always something else requiring an expenditure — a birthday, anniversary, or wedding — and so there’s nothing left."

I’m starting to repeat myself. So I will just leave it like that. You tell me why Nancy and Ed can’t buy a house.

There is a fourth story about Robin and Jack. They make $160,000 a year. They bought a house in Norwalk, Connecticut for $487,000 with the help of their parents for down payment. The author laments that Robin and Jack live paycheck-to-paycheck because their mortgage costs them $2,500 a month.

What should we do about it? How do we make housing affordable? Ms. Draut recommends that the government should cap the mortgage interest deduction to $10,000 a year and make it refundable for families earning less than $50,000 a year. She said the government should use the extra revenue for a matched savings program (dollar for dollar for first-time home buyers earning less than $50k a year).

I’m OK with reducing or removing the mortgage interest deduction. That’s one reason why house prices are expensive. People already have a natural preference toward buying a house. I don’t think the government needs to put in an extra inducement. A subsidy creates more demand. More demand translates into higher prices. Let’s not reduce one subsidy and create another simultaneously. Canada for example does not give tax deduction for mortgage interest. They don’t exempt profits on home sales from taxes either. They also don’t have GSEs like Fannie Mae and Freddie Mac holding the mortgage interest rate down. Take a look at the mortgage rates at a random Canadian bank. Note there is no 30-year fixed rate refi-anytime mortgage. The longest you can have your rate fixed is 10 years. However according to Wikipedia, the home ownership rate in Canada is just as high as in the U.S. The neighborhoods and communities in Canada are just as strong, if not stronger.

Separately, a recent Newsweek column The Homeownership Obsession by Robert J. Samuelson said it much better than I can. Let’s stop being obsessed about pushing everybody into home ownership.

He’s Taking Law Into His Own Hands To Help Broke Homeowners (Wall Street Journal) - Via Credit Slips. A sheriff refuses to kick out foreclosed homeowners. A sheriff simply doesn’t possess the power of a judge. Well intentioned, but I think Mr. Green clearly crossed the line.

Subsidized in the City (Newsweek) - Thumb up for a 25-year-old girl from a wealthy family wanting to live on her own in New York city.

Struggling In Ohio As The Economy Tightens (NPR) - Via FatWallet. For some reason NPR changed the title of the article after I bookmarked it. It used to be “For Some Ohioans, Even Meat Is Out Of Reach.”

Federal Government Off-Balance Sheet Entities (Credit Slips) - Fannie Mae and Freddie Mac are the federal government’s Structured Investment Vehicles, in the same category as Enron’s off balance sheet vehicles Chewco and LJM1 and LJM2. Good thought.

1. Mail a check. A check in the mail probably takes a week to get there. Then my recipient can take it to their bank and have the bank collect it. I don’t know how long that will take. I’m guessing another week or two. So total 2-3 weeks. In terms of cost, there is only postage (< $1) on my side. The recipient’s bank perhaps will charge a small amount for collecting a check from the U.S. but I imagine it will be minimal too. This is probably the lowest cost option but it will take longer than I’d like.

2. Western Union or MoneyGram. I can also use Western Union or MoneyGram. These services let me transfer money almost instantly. The going rate is about $10-15 for my $100 transfer, more for higher amounts. The cost is too high for me.

3. Wire Transfer. I can also go to a bank and use their wire transfer service. This is even more expensive for transferring a small amount because the fee is usually fixed for any amount. An outgoing international wire transfer can cost me $40. That’s way too expensive for sending $100. Washington Mutual advertises free outgoing wire transfers for their account holders. Then it says "non-refundable foreign currency exchange charges and intermediary and beneficiary bank fees may apply." I don’t have an account with Washington Mutual so I don’t know what those charges will be.

4. Bank Partnership Remittance Service. I don’t know if that’s the proper name for this kind of service. Some banks established service partnerships with some other banks in other countries. They offer remittance service which lets customers send money to those specific countries. The recipient either sets up a bank account with the partner bank or picks up cash from the partner bank. Because it’s a bank-to-bank partnership, the service does not cover all countries. It also requires the recipient to do something with a partner bank on the other side. If they happen to use that bank or that bank has a branch location near them, great. If not, the partner bank may not be convenient for them.

This is the service I ended up using. Fortunately Mexico is a popular country for this kind of service. At the bank I used (Wells Fargo), their ExpressSend service covers Mexico, El Salvador, Guatemala, China, India, Philippines, and Vietnam. For Mexico, the partner banks are HSBC Mexico, Banorte, and BBVA Bancomer. My recipient also happens to use one of these banks. That made things a lot easier. I went to the bank and I gave them the recipient’s name, address and phone number. If I need to send money regularly, I can also give them the recipient’s bank account number and set up an ongoing link. Because it was only a one-time transfer, I selected the "cash pickup" option.

Two days later, my recipient told me he got the money. Problem solved. Because of my other account relationships with Wells Fargo, they didn’t charge me any fee for this service (otherwise $5). The exchange rate was about 2% less than the wholesale rate reported on Yahoo! for that day. So that’s how the banks make money. For a one-off transfer of $100, a cost of $2 is reasonable for me.

If someone needs to send money regularly, there are probably other more convenient and/or less expensive options. Do you know any of them?

• Stories from Strapped: College Education
• Stories from Strapped: Paycheck

Chapter 3 in Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead is Generation Debt. I think we all know what that means. The author says the younger generation can’t get ahead because they have too much debt. Now, the stories:

Lori, a 33-year-old living in Manhattan, still has $40,000 in student loans debt. She earned only $16,000 a year in her first job as a social worker and community organizer in New York. Her income "inched upward" over time but it’s still not enough to pay all her bills and loan payment. So she deferred payments on her student loans.

Ah, living in Manhattan on $16,000 a year. The book doesn’t say what Lori’s current salary is but even double that, at $32,000 a year, it’s still going to be tough living in Manhattan. When I was in New York city a few months ago, I rode in the commuter train on a random workday. It was packed. There was hardly any standing room. I’m sure many of the commuters earn much more than $32,000 a year. I’m guessing they chose to spend a lot of time commuting every day because the living expenses are lower outside of New York city. Between paying off debt and spending less time commuting, Lori chose the latter.

Next story:

Elaine got her credit card in college and a free T-shirt too. She used her credit card to pay for tuition and living expenses because her parents couldn’t help pay for college. Elaine plays the credit card game well. She transfers balance from one card to another every six months for the low introductory rates. She now owes $40,000 but half of it was racked up after college. She bought a new computer and new furniture because she "wanted to make her apartment look like an adult’s apartment." She also used credit cards to pay for her wedding and flights for family visits. Elaine has no regrets. She thinks about the things her cards enabled her to do: studying in Scotland, flying to Paris, her perfect wedding.

This is a good story. I want my home to look good too. If I don’t have to pay back the money, I would also like to have a perfect wedding or study in Scotland. Elaine is not afraid of debt. She used debt for "consumption smoothing." She was able to do things she didn’t have money for. I flash back to my student days. I did many things which looked silly now, like working in the college cafeteria serving nacho and cleaning up, for minimum wage $4.25/hour plus free food. Until today I still have my employee badge with that food service contractor. It serves as a reminder of the days when I was poor. I knew I would earn a much higher salary after I graduated. I had credit cards but somehow carrying a balance simply wasn’t an option for me. I wasn’t as smart as Elaine. My college years would’ve been much more comfortable if I borrowed from my credit cards.

The third story:

David and Lisa, both 31, have Ivy League degrees. They bought their home when they were 28. They earn $86,000 together in Cincinnati but they also have $40,000 in credit card debt. Their credit card debt has grown since they got married. David calls it "unavoidable debt" because the debt came from the cost of traveling around the country for friends’ weddings, holiday trips to visit their families and the cost of clothing and feeding their two children. David acknowledges that going to weddings and visiting family is a major source of their debt but they believe seeing friends and family is more important. They are now trying to move to a larger house with a real backyard and enough bedrooms so each of the boys can have his own room. Seven years after they got married, they are basically treading water because they have as much debt now as seven years ago.

Once again we see David and Lisa made the life style choice between debt and attending friends’ weddings because they think the latter is more important. Although I wouldn’t make the same choice, I don’t want to judge or criticize their choice either. It’s their life. They get to choose how to live it. There’s nothing right or wrong about it. But we can’t say they can’t get ahead. They chose not to.

The author suggested some public policy changes to deal with the consumer debt problem.

1. Allow credit card rate increases only on new balances, and not existing balance. I can see the arguments on either side. Borrowers say it’s unfair to have a higher rate apply to money they already borrowed. Credit card companies say because the loan is revolving, it’s actually renewed month-to-month. If the borrower doesn’t like the new rate, they can transfer the balance to a different card, just like what Elaine in the book did. There is so much competition in credit cards. If a company raises their rate willy-nilly, it risks losing a profitable customer.
2. Ban credit card solicitations on college campuses. OK, not a problem, although I’m not sure how effective it’ll be in reducing the debt people have. If we decide that credit cards are a dangerous product and we want to protect our younger generation, we could raise the minimum age for obtaining a credit card to 25, like we have minimum age for smoking and drinking. We could also require a test for debt management and financial responsibility before someone can get a credit card, like we do before a gun license or a driver’s license can be issued. These measures will be much more effective than merely banning on-campus credit card solicitations because college students have plenty of exposure to credit card ads elsewhere: online, on billboards, on TV and in newspapers and magazines.
3. End predatory lending in mortgage refinance. Fees, points, and prepayment penalties are too high. Expensive products are everywhere. Let’s protect the consumers and regulate the prices. We should start with weddings, jewelry, furniture, designer apparel, shoes and accessories, and cosmetics and perfumes because their profit margins are too high. These expensive products are draining the wallet of our younger generation. But who gets to decide when something is worth or not worth the price?

Credit card companies make easy targets for the blame game. They are not saint but they are just like other companies working hard for making a profit. The credit card industry is very competitive. The cost of switching is negative (low introductory rates and sign-up bonuses). More laws and regulations are great on the supply side. Let’s not forget the demand side either. Let’s also make a law that caps the debt-to-income ratio or the debt-to-assets ratio for young adults. That’ll guarantee that our younger generation will not have too heavy a debt load dragging them down. As we have seen, self-discipline isn’t working. People willingly take on credit card debt despite the bad press credit card companies receive. We don’t let anyone buy alcohol, tobacco, prescription drugs, or guns at will. Limiting how much our citizens can borrow isn’t too far fetched. Or else they shoot themselves in the foot.

Or we can just let adults be adults. The perpetual "guns kill or people kill" argument lives on.

How do you make people do the right thing for themselves? This isn’t only credit cards. It applies to smoking and eating healthy too. I think it’s common knowledge that french fries are not good for one’s health. Yet the amount of french fried consumed every day in this country is probably measured by thousands of tons. People want french fries. Restaurants happily serve them. Whose problem is it that people eat too much fries?

"Also, never ever borrow against your 401k plan because you will pay double taxation on the money you borrow. Because you don’t pay taxes on the money you put into a 401k, when you pay back the loan (which you must do within five years, or 15 years if used to buy a home), you pay it back with money you have paid taxes on. Then, when you retire and take the money out again, you end up paying taxes on it a second time."

This allegation is all over the place — MSN, USA Today, The Motley Fool, Moolanomy blog. It is a myth because there is NO double taxation. It’s a mind trick similar to that well-known "where’s the missing dollar" puzzle. 

"Three men went into a hotel. The manager said the room was $30 so each man paid $10. A while later the manager realized the room was only $25 so he sent the bellboy to the 3 guys’ room with $5. The bellboy only gave each man $1 back and kept the other $2 for himself. Now 3 men paid $9 each for the room, which is $27. Add the $2 that the bellboy kept, and that’s $29. But the 3 men paid $30 originally. Where is the other dollar?"

I was able to find a good explanation for this puzzle. The $30 number is irrelevant. The correct math is $27 - $2 = $25. It makes no sense to add $2 to the $27 because it’s already a part of the $27. The $2 should be subtracted from the $27.

Now, back to our 401k double taxation myth. The fact that the loan has to be repaid with after-tax dollars is irrelevant, just like the $30 number in the hotel puzzle. If you didn’t borrow from the 401k plan but you borrowed from a bank, you’d have to pay the bank back with after-tax dollars as well. If you didn’t borrow from your 401k plan but you dipped into your own savings, you have to replace those savings with after-tax dollars too. What it really means is that a 401k loan is not tax deductible, just like any other consumer loan except a mortgage or a HELOC. Instead of saying you will be double taxed, they should just say that a 401k loan is not tax deductible, plain and simple.

I have this post in draft for a long time but Jonathan at My Money Blog beat me to it recently with two posts trying to debunk this myth (post 1, post 2). After so much discussion some folks are still not convinced. I think this issue is best illustrated by this chart below:

The left hand side represents a typical consumer loan, like a car loan. The arrows represent "borrows from" and "pays back to." You borrow from a bank. The bank borrows from the financial market. Your 401k invests in the financial market. I think we all agree there is no double taxation in this case. You pay after-tax dollars to the bank for both principal and interest. Your 401k earns from the financial market but the earnings have to be taxed when you withdraw from your 401k.

The right hand side represents a 401k loan. Now, if you put an imaginary box in the middle on the right hand side, it becomes exactly the same as the left hand side. You borrow from an imaginary middleman and pay after-tax dollars for both principal and interest. This imaginary middleman then borrows from your 401k and passes the same dollars it receives from you to your 401k. All of a sudden you are not double taxed any more because it looks exactly the same as a car loan on the left hand side. Because this middleman is only imaginary, it follows that you are not double taxed with a 401k loan, whether for the principal repayments or for the interest.

Whether or not you are mathematically better off with a 401k loan depends on how these three rates play out:

• your alternative after-tax interest rate from a bank loan
• what bond funds in your 401k are expected to earn from the market
• the interest rate on your 401k loan

Suppose your alternative after-tax interest rate from a bank loan is 7% and the interest rate on your 401k loan is 5%. If you borrow from your 401k, you save 2% in interest cost in after tax dollars. But also suppose the bond funds in your 401k are expected to earn 8%. If you borrow from it, your 401k plan can only earn 5% from you. So your 401k plan account is 3% worse off in before-tax dollars. Between 2% better off after tax and 3% worse off before tax, it can become a wash. The reason you have to compare it with what bond funds can earn is because the 401k loan payments are not subject to market fluctuation. If you do borrow from your 401k, increase your allocation to stocks for what’s left in the plan.

While there is no double taxation on a 401k loan, there are other negatives on borrowing from your 401k plan. The biggest negative is that if you change jobs (voluntarily or involuntarily), you often have to repay the outstanding balance of the loan within a short period of time, like 60 days. Some plans actually allow you to continue the loan repayment even after you terminate employment, but not all plans do that. If you really need cash and you don’t have any other source except your 401k, taking out a 401k loan is at least better than taking a hardship withdrawal from the plan. Just be absolutely sure you will be able to repay the loan and you won’t change jobs before paying off the loan. And don’t reduce your regular 401k contributions while you are paying off the loan.

• Strapped: College Education

Chapter 2 in Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead is Paycheck Paralysis . It says the younger generation can’t get ahead because they don’t get good jobs. They have become Bouncers , Jugglers , Tempsters , and the Pajama Class . The stories are as good as the ones in the previous chapter.

Bouncers:

Susan had seven jobs in six years after she graduated from college. She quit her first job because she wanted to live close to her future husband. She left her second job because another job offered a higher salary, and she quit her third job because the hours were too long. She left her fourth job because a startup gave her substantially higher salary and commission. After the startup failed, she was unemployed for a while. Then she got into retail, her sixth job. She left the retail job for law school. Now she works for a non-profit while attending law school.

The author said these frequent job changes are a result of flawed economy. Except for the failed startup and the aftermath of the dot com bubble, I don’t see where the economy has anything to do with it. She left one job for another voluntarily for personal reasons, often for higher pay.

Jugglers:

Anna worked several jobs while going to community college. After that she worked for a government agency for 3-1/2 years until she decided to go to an art school in San Francisco. She worked several part-time jobs while she went to the art school. The $15,000-a-year tuition and fees were paid by student loans. Her part-time jobs paid her living expenses. Anna estimates she will have $76,000 in student loan debt after she’s done with the art school.

Working and going to school at the same time is tough. I don’t know what made Anna leave her comfort zone at the government agency for an art school in San Francisco, but we’ll have to respect her decision. She thought it was worth it despite the huge student loan debt she will have. Otherwise she wouldn’t have decided to go to an art school in one of the most expensive cities in the country.

Tempsters:

Dylan has a bachelor’s degree in screenwriting from NYU. When she graduated, she was only able to get a job as a receptionist at a production studio in New York earning $17,000 a year. She then worked as a freelancer for a few magazines. Five years after graduating from college, she got her first full time salaried position in New York City earning $35,000. Because the expenses were so high relative to her income, she had to file bankruptcy. Now, 10 years after she graduated, she earns $45,000 but she still has $15,000 student loans debt which couldn’t be eliminated in a bankruptcy.

New York City is expensive! Everybody knows that, right? I bet she’ll have a more comfortable life if she lived elsewhere.

The Pajama Class: No story but basically writers, editors, and designers who work in the "creative industries" work from their home as freelancers without the security of a steady salary or benefits. According to the book, 83% of the Pajama Class prefer the flexibility and freedom as a freelancer. The rest want a full-time job but can only get freelance work.

It’s tougher to make a living now because we are competing in a global economy with a global workforce. Manufacturing jobs shrank. Even some white collar office jobs are outsourced overseas (example). When we directly compete with lower paid workers in other countries, our wage growth slows or stagnates. That’s the unfortunate effect of globalization.

The author made two proposals to get us back on track. The first proposal is creating more career ladder programs in which people can be trained on the job and grow their career. Teaching assistants can train and become teachers. Nursing assistants can become registered nurses. This is a good proposal and I agree with it. The second proposal is making it easier to unionize. I’m not too sure about this one because a union may be able to hold up the wages for its members but more jobs will just go overseas. Imagine a world in which people in union jobs are paid well while others don’t have a job. I’m not sure as a country we are better off that way.

Any thoughts? More to come. Next week we will look at debt.

1. Roth IRA. If you are eligible, contributing to a Roth IRA is a good alternative to a no-match 401k or 403b. Because a Roth IRA is under your own control, you can buy low cost funds in your Roth IRA. The lower your costs, the more investment returns you get to keep.

2. Non-Deductible IRA. If you are not eligible for contributing to a Roth IRA, you are still eligible to contribute to a non-deductible Traditional IRA. The contributions are not tax deductible but the investments grow tax deferred inside the IRA. Under the current law, there is an opportunity to convert a non-deductible Traditional IRA to a Roth IRA in 2010 and thereafter. This 2010 Roth conversion issue is beyond the scope for this post. See Should I Contribute To A Non-Deductible IRA? Part 1, Part 2 on My Money Blog for more information. For the purpose of this post, I assume the non-deductible IRA is going to stay as-is and not converted to Roth.

3. Taxable Account. Another alternative to a high cost 401k or 403b plan is investing in a regular taxable account. If you buy tax efficient stock funds, the majority of your returns will come as unrealized capital gains which are not taxed until you sell. When you do sell, under the current laws, the long-term capital gains are taxed at a more favorable rate than ordinary income.

4. Contribute to the plan and then rollover. The alternatives are not necessarily better than contributing additional money to the 401k or 403b plan even if the cost is high and there is no match. This is true especially if you are not going to work for this employer for very long. When you leave your employer, you can rollover the balance in your 401k or 403b plan to your own IRA. Then you will be able to use low cost funds. You just have to hold your nose and pay the high cost until you are liberated from the plan. A key input is how many years you will have to pay the high cost.

Finally, here is the spreadsheet that compares these options:

alternatives to high cost 401k or 403b plan

You will need the estimated tax rates, investment return, extra cost in the plan, how many years you will be in the plan and how many years you have until withdrawal. It then calculates "advantage over 401k" for each alternative. If the result is positive, it means that’s a better option. If it’s negative, it means it’s still better to contribute to the high cost 401k or 403b plan and wait for the rollover. In many cases you will find that Roth IRA is better than a high cost 401k or 403b but the other two options are not. For example, under this set of assumptions,

we get

In this example, a Roth IRA is 7.2% better than a high cost 401k or 403b plan; a non-deductible IRA is 16.9% worse; and a taxable account is 19.9% worse. That’s why you often hear about the rule of thumb: 401k for the match, then Roth IRA, then back to 401k. If you are not eligible for Roth IRA, the spreadsheet also indirectly compares a non-deductible Traditional IRA with a taxable account. In our example if you max out the 401k and you still have money to invest for retirement, you should do the non-deductible IRA before you invest in a taxable account because a non-deductible IRA is not as bad as the taxable account.

Feel free to plug in numbers applicable to yourself and see how the alternatives play out for you.

Notes:

1) Front-end load is often waived for 401k and 403b plans. Please verify with plan administrator.