Laying Down the Laws of Family Finance to Legal Eagles

Marriage sent a wake-up call to Bill and Kelly O’Kelly, two thirtysomethings who had allowed their spending to run amok during their freewheeling single days.

When they wed in 1995, the couple had $42,000 in credit card debt, mostly from impulse purchases, vacations and restaurants. Bill, a lawyer, had a habit of charging plane tickets to attend baseball games across the country, and Kelly, a legal secretary, would think nothing of popping over to Palm Springs on a whim.

Matrimony, however, inspired the Thousand Oaks couple to get their finances in order by cutting back frivolous spending and paying off credit card debt. No longer focused on living for the moment, the O’Kellys have committed themselves to securing their future. They’re saving for retirement and building a tidy college fund for their children, yet maintaining a comfortable, not extravagant, lifestyle.

“We got married relatively late in life, and when we did, it was a mess of a financial picture,” said Bill, 39. “We both make good incomes”--their combined annual gross is about $138,000--”and that led us to being undisciplined. We didn’t believe in delayed gratification. But once we got married, we wanted to buy a home and start a family.”

And so they did. Now the challenge for the couple is to think carefully about what their priorities are and how they will go about meeting them.

Sizing Up the Balance Sheet

“Your timing in looking for help is absolutely appropriate,” said Mitchell Freedman, a fee-only certified financial planner and accountant in Sherman Oaks. “You’ve come to a place in your life where you want to avoid past mistakes and start a new life on a sound financial foundation.”

The O’Kellys’ assets include $16,000 equity in their Ventura County home, which they bought this month for $320,000 and have both first and second mortgages on. They borrowed $26,000 from their 401(k) retirement accounts--they work at the same Los Angeles law firm--to make the $16,000 down payment and pay closing costs.

Bill’s father, who died last October, left Bill his Sacramento home. Bill expects to net between $17,000 and $21,000 from the property, which is now on the market. The couple also own vacant parcels in Montana and Twentynine Palms that together are estimated to be worth less than $10,000.

For retirement, Bill and Kelly have about $30,000 left in their 401(k)s and about $65,000 in various individual retirement accounts.

Their other assets include $4,500 in cash savings and two investments Bill’s father gave him--about $2,000 in BankAmerica Corp. stock and $3,000 in the Prudential Utility B fund (three-year average annual return: 19%).

The couple’s only other debt, aside from mortgage and 401(k) loans, is $8,000 remaining on Bill’s student loan. The couple paid off their credit card debt with part of $70,000 left to them by Bill’s father. (About $15,000 of that gift has gone toward making mortgage payments on the vacant Sacramento home.)

“I think the two of you are very fortunate,” the planner told the couple. “You have a good, steady income, and you didn’t buy too expensive a house. I also think you made a very wise investment to pay down your consumer debt from the inheritance, because it puts you on solid footing to move ahead.”

They’re going to need it. Their $2,600 monthly mortgage obligation, for instance, exceeds their previous rent by $1,550. After their first child is born in December, Kelly plans to take a three-month unpaid maternity leave, then cut back to a four-day workweek, reducing her pay by 20%.

The couple are considering having a second child within a few years. In that case, Kelly might scale back her work obligations further or perhaps not work at all while the children are young.

“One of the most significant issues you face is how long Kelly works,” Freedman told the couple. “With Kelly working, you’ll be able to put money aside. If Kelly doesn’t work, it could have a significant impact on your long-term plans.”

Retirement savings, for example. For purposes of illustration, say Kelly, now 35, does not work at all from age 37 through 42, and she wants to retire at age 60. Suppose further that her 401(k) savings realized an average annual return of 8%. The cost to her at retirement of forgoing five years of tax-deferred saving at her present rate of contribution would be roughly $165,000.

“We’re finding couples really need two incomes not only to meet their retirement needs but lifestyle needs,” Freedman said.

Diversifying Retirement Investments

In considering the couple’s entire retirement savings portfolio, Freedman said they need to make some changes that will ensure that their investments are well-diversified so they’ll be cushioned from severe market falls and that the money invested outside their 401(k)s is in mutual funds with strong performance histories and low fees.

The couple’s 401(k) contributions--both have been contributing the maximum--are spread among three Merrill Lynch funds offered through their company’s plan: 40% in a growth fund, 40% in a small-cap value fund and 20% in a global fund that invests in stocks, bonds and other securities.

Unfortunately, the alternatives for the couple’s 401(k) choices are extremely limited. After looking at the growth fund’s largest holdings, Freedman suggested they switch that 40% allocation to a value fund he believes would be more likely to perform better. The couple would reduce the small-cap percentage to 25% and put 20% in a bond fund, 10% in a government securities fund and 5% in a money market fund. Future contributions would follow the same pattern.

“I’d like to cushion your retirement savings from as much volatility as possible but still have you invested in securities,” he said.

In looking at the couple’s IRA choices, Freedman said Bill should keep the $7,600 IRA he has invested in the Vanguard Index-Trust 500 Portfolio (three-year average annual return: 23.8%) and the $2,000 Roth IRA in Vanguard Index-Trust Value (three-year average annual return: 19.5%). Likewise, Kelly should keep her $2,000 Roth IRA in the Vanguard Index 500 fund, but the planner encouraged her to overhaul her other IRA portfolio, worth about $54,000.

This traditional IRA is invested in four Pioneer front-end-load funds: $17,300 in Capital Growth (three-year average annual return: 5.2%); $15,000 in Small Company (fund is less than 3 years old); $10,000 in Growth (three-year average annual return: 25%); and $10,000 in Micro Cap (three-year average annual return: -25.6%). She also has $2,000 in a DSI Realty Income fund.

Freedman advised keeping the Growth fund but selling the rest, with the proceeds to be allocated as follows: $15,000 to American Century Income & Growth (three-year average annual return: 24.1%); $10,000 to BT Investment International Equity (three-year average annual return: 14.8%); $10,000 to Vanguard Index Total Bond (three-year average annual return: 8.5%); $5,000 to Baron Asset (three-year average annual return: 12.6%), a small-cap growth fund; and $5,000 to Sound Shore (three-year average annual return: 20.9%), a mid-cap fund with a value bent.

In saving for their children’s education, Freedman recommended that the O’Kellys invest $500 a month as follows: 30% to Vanguard Index 500; 20% to Vanguard Index-Trust Extended Market (three-year average annual return: 11.4%); 15% to Vanguard Index-Trust Small Cap (three-year average annual return: 8.5%); 15% to Vanguard International Growth (three-year average annual return: 7.4%); 15% to Vanguard Total Bond; and 5% to Vanguard Equity Index Emerging Markets (three-year average annual return: -12.4%).

How Quickly to Repay 401 Loans?

To give the education fund a big head start, Freedman suggested that the O’Kellys consider investing the proceeds from selling the Sacramento home rather than using it to speed repayment of their 401(k) loans.

Generally, the planner said, borrowing from a 401(k) should be seen as a last resort, but because the O’Kellys have already done so, they need to consider whether repaying their account is the best choice for that money.

“If you start with $20,000 and invest it the right way with the kind of time horizon you have, it would compound quite substantially by the time your first child goes to college,” he said.

That plan could create problems, though, if Bill or Kelly were to change employers. Freedman said many employers will accept a plan-to-plan 401(k) transfer, which means the couple could continue to repay the loan over its 30-year term. But in many cases, an investor who has borrowed from his or her 401(k) will find that the debt has to be repaid within a short period after termination of employment. If the loan is not repaid within that time, it becomes a taxable distribution.

Freedman also urged the couple to build their emergency fund until it reaches about three months’ worth of expenses. He encouraged them to add $500 a month to their money market account until it reaches $10,000.

“Do it in a disciplined way and do it religiously,” he told them. “Pay yourself as if it’s a bill.”

Freedman added that they should keep an eye on interest rates and on the market value of similar residences in their neighborhood to determine whether they’d be able to refinance their home and save interest costs. With more equity in their home, the couple would be in a better position to get a single mortgage on more favorable terms than the two they have now.

*

Diane Seo is a regular contributor to The Times. To participate in a published Money Make-Over, send your name, age, phone number, income, assets and financial goals to Money Make-Over, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. We cannot respond to all inquiries.

Information about choosing a financial planner can be found at The Times’ Web site at https://www.latimes.com/finplan. The site offers stories, phone numbers, addresses and links to related sites.

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This Week’s Make-Over

* Investors: The O’Kellys, Bill, 39, and Kelly, 35

* Occupations: Bill, attorney; Kelly, legal secretary

* Combined gross annual income: About $138,000

* Financial goals: Save for retirement and build education fund for children.

Current Portfolio

* Real estate: About $16,000 equity in Thousand Oaks home, with about $304,000 remaining on two mortgages; Bill expects to net $17,000 to $21,000 from the sale of inherited Sacramento home, now on market; two vacant parcels out of the area worth less than $10,000.

* Debts: $26,000 owed to 401(k)s; Bill owes $8,000 on a student loan.

* Retirement accounts: A combined total of $30,000 left in 401(k) plans, invested in three funds through Merrill Lynch: Special Value, Growth for Investment & Retirement, and Global Allocation. Kelly has $54,000 in an IRA, spread among DSI Realty Income Fund and four Pioneer mutual funds: Capital Growth, Growth, Small Company and Micro Cap. Kelly also has $2,000 in a Roth IRA, invested in Vanguard Index 500. Bill has about $7,600 in a traditional IRA, also invested in the Vanguard Index 500, and $2,000 in a Roth, invested in Vanguard Index Value.

* Stocks and other mutual funds: About $3,000 in Prudential Utility B; $2,000 in BankAmerica stock

* Cash: $4,500 in money market and savings accounts

Recommendations

* Build emergency fund to $10,000 by adding $500 a month to money market account.

* With retirement savings, aim for a more diversified, lower-expense portfolio.

* Contribute $500 a month toward children’s education fund; consider investing proceeds from the sale of inherited property for this purpose. College savings should also be invested in a diversified selection of no-load mutual funds.

* Consider refinancing home in the next few years.

* Buy additional disability insurance, and purchase umbrella liability policy for home.

Recommended Mutual Fund Purchases

American Century Income & Growth (800) 345-2021

Baron Asset (800) 992-2766

BT Investment International Equity (800) 730-1313

Sound Shore (800) 551-1980

Vanguard Index-Trust Extended (800) 992-8845

Market Portfolio

Vanguard Index-Trust Small Capitalization Stock Portfolio

Vanguard International Growth

Vanguard International Equity Index Emerging Markets Portfolio

Vanguard Bond Index Total Bond Market Portfolio

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Meet the Planner

Mitchell Freedman is a fee-only certified financial planner and certified public accountant in Sherman Oaks. He is the founder of Mitchell Freedman Accountancy Corp. He was named by Worth magazine as one of the country’s 300 outstanding financial planners in 1997 and 1998.