Dear Liz: I will be inheriting around $300,000 over the next year. My instincts are to pay down debt with this money. I have two homes and for practical reasons need to keep them. One home has a $260,000 mortgage balance at 5%. The other has a $130,000 mortgage at 4%. We have $35,000 in credit card balances. Some are telling us to invest. I think we should pay off all the credit cards and then pay down the larger mortgage by $100,000 or more. Am I on the right track?
Answer: Paying off your whopping credit card debt is a great idea. You need to figure out, though, what caused you to rack up so much debt and fix that problem. Otherwise, you're likely to find yourself back in the hole.
Paying down a mortgage is a trickier proposition. Most people have better things to do with their money than prepay a low-rate, tax-deductible debt. Before they consider doing so, they should make sure they're saving adequately for retirement, that all their other debt is paid off, that they have a substantial emergency fund of at least six months' worth of expenses, and that they're adequately insured with appropriate health, property, life and disability coverage. Those with children should think about funding a college savings plan.
If you've covered all these bases, then paying down and perhaps refinancing the larger mortgage makes sense.
Self-directed IRAs carry risks
Dear Liz: My 401(k) plan has grown exceptionally well this year. I think we all know that it can't last. I just recently heard about self-directed IRAs. I was intrigued at the possibility of opening one by rolling over a portion of my 401(k) money directly. The problem is, my company's 401(k) provider will not allow the direct rollover of funds. Is there an alternative means of withdrawing 401(k) funds without penalty and still get them into a self-directed IRA?
Answer: You can quit your job. Otherwise, withdrawals while you're still employed with your company will trigger taxes and probably penalties.
Your premise for wanting to open a self-directed IRA is a bit misguided, in any case. Your 401(k) balance may occasionally drop because of fluctuations in your stock and bond markets, but over the long term you should see growth.
You may have been sold on the idea that self-directed IRAs would somehow be less risky. Some companies promote self-directed IRAs as a way to invest in real estate, precious metals or other investments not commonly available in 401(k) plans. The fees these companies charge as custodians for such accounts are usually much higher than what they could charge as traditional IRA custodians, so they have a pretty powerful incentive for talking you into transferring your money to them.
The problem is that you could wind up less diversified, and therefore in a riskier position, if you dump a lot of your retirement money into any alternative investment. It's one thing for a wealthy investor to have a self-directed IRA that invests in mortgages or gold, assuming that he or she has plenty of money in more traditional investments. It's quite another if all you have is your 401(k) and you're putting much more than 10% into a single investment.
Also, there's a lot less regulation and scrutiny with self-directed IRAs than with 401(k)s, which increases the possibility of fraud. (Southern California investors may remember First Pension Corp. of Irvine, a self-directed IRA administrator that turned out to be a Ponzi scheme.) So you'd need to pick your custodian, and your investments, carefully. You also would need to understand the IRS rules for such accounts, because certain investments — such as buying real estate or other property for your own use — aren't allowed.
If you're determined to diversify your investments in ways your current 401(k) doesn't allow, you can open a regular IRA at any brokerage and select from a wider variety of investment options. Or you can look for a self-directed IRA option with low minimum investment requirements to start.