Choosing the Best Mutual Funds

Question of the week: I've just come into a small inheritance and I want to sock it away for the future. Everyone tells me that I should be looking into stock mutual funds. If you were to believe all the mutual fund advertising, you'd think that every fund is a winner. How do I really know which fund is any good? --Joel

Dear Joel,

For people who don't have the time and expertise to research and track individual stocks--which includes most of us--mutual funds are one of the best possible ways to invest. And a lot of other investors agree--the Investment Company Institute, the trade group for the mutual fund industry, says that Americans have nearly $7 trillion stashed away in mutual funds.

But there are thousands of fund choices, so it's very important to sort out the weak from the chaff. We recently asked the Armchair Millionaire community for its advice on what to look for when shopping for a fund. They offered us this battle-tested wisdom:

Check out the management. "I look for long-term management. I want my fund managers to have been in their jobs for a long time--at least seven years." --Cole

Consider fees. "I look at the fees first. Just because a fund charges higher fees doesn't mean that it is well managed. If a fund has above-average fees, I skip it." --ACF

Compare returns to a benchmark. "The past performance of a fund alone is meaningless. You have to compare it to how the market overall has done. I always compare large cap funds to the S&P 500 index and small cap funds to the Russell 2000." --James49

Watch the tax impact. "I want my money managed for the least taxable exposure. I expect my fund managers to be able to manage the fund for maximum tax efficiency." --Presto

It's also important to know what not to do when choosing a fund. Use my checklist to avoid the most common mutual fund mistakes.

The Armchair Millionaire's Checklist of Mutual Fund No-Nos

• Don't pay a load. Loads, or sales fees, come straight out of your investment. There's no evidence that load funds perform any better than no-load funds, so keep your money and stick with the no-loads.

• Don't overlap. Funds are themselves a diversified investment, but don't think that owning a lot of funds means that you'll be even more diversified. Instead, you may end up with many funds that own the same stocks. You should be able to achieve adequate diversification with as few as two or three funds that target different areas of the overall stock market.

• Don't chase performance. Last year's hot fund can be this year's laggard. Making your fund choices based on recent performance has historically been a losing proposition. Look for long term histories through a variety of market conditions such as bull markets, bear markets, recessions and periods of economic growth.

• Don't trade in and out of funds. Trying to time your investment and switching frequently between funds is pointless. You invest in funds to leave the trading up to a professional, so leave your money in your funds long enough for the portfolio managers to do their jobs.

THE BOTTOM LINE: All mutual funds are not created equal. When you choose a mutual fund, you're really choosing a person or a team to manage your money. Use common sense and make sure to get objective advice before you make a purchase.

Transform Yourself Into an X-Treme Saver

Question of the week: My New Year's Resolution this year was to save 20 percent of my paycheck. So far, I've failed dismally--there's never enough left at the end of the month to save! How can I make my savings plan work? --Striving to Save

Dear Striving,

Congratulations on your ambition to join the ranks of the x-treme savers--people who are aggressively stashing away a substantial portion of their earnings each month in order to achieve their dream of financial freedom. When we asked members of the Armchair Millionaire community about their savings habits, we found that there are plenty of people who are regularly saving 20, 30, or 40 percent of their income. A few are saving even more.

But as you've discovered, this sort of x-treme saving doesn't just happen. Here is a sampling of the good advice we got from the community on reducing spending and increasing savings.

Tax yourself. "Upon depositing my paycheck, I 'tax' myself by peeling off an extra 20 percent and sticking it in a separate account. Every two or three months I use my 'tax' account to fund a larger investment." --Ray

Live on one salary. "When my wife and I were first married, we decided to live only on my salary and save hers. This way, when we decided to have children, there wouldn't be much of a financial disruption and we wouldn't be dependent upon us both working forever." --Bryan J.

Make a lot out of a little. "I've never made a lot of money but I do manage to put away about 25 percent of my salary each month when you include 401k/IRAs. My trick? I guess I decided long ago how I want to live (simply) and I just don't need the extra money. So I save it." --Polly T.

Anyone can do it. "Something I have learned along the road to financial education is it takes planning and discipline--and I should know--10 years ago I declared chapter 7!" --Paula

These ideas will just get you started. My checklist has more tips that will help turn you into an x-treme saver.

The Armchair Millionaire's Checklist for Painless X-Treme Saving

• Pay yourself first, automatically. Arrange to have money automatically regularly deposited into a savings or investment account, either directly from your paycheck--as with a 401(k)--or from your checking account. Either way, this money will be safely tucked away before you miss it.

• Save your next raise. Most people just tend to spend any increase in their income. Instead, whenever you get a raise, commit to saving that amount.

• Remind yourself. Leverage technology to send yourself regular reminders about saving. You can set up an email reminder, program your Palm, or schedule an automatic transaction in your personal finance software.

• Re-direct debt payments. Whenever you pay off any loan, send the payments you were making into your savings. Same goes for the amount you save by refinancing your mortgage.

• Ignore the Joneses. Keeping up with the spending habits of your neighbors or friends is a dead-end street. Live below your means and save the difference.

THE BOTTOM LINE: There are few things that will bring you to financial independence more quickly than x-treme saving. While you may find it difficult to get started, you'll soon find that it's one of the most rewarding--and addicting--things you can do.

The Battle of the IRAs

Question of the week: My current employer doesn't offer a 401(k) but I'm determined to continue saving for retirement on my own. I've started to look into individual retirement accounts, but I'm not sure which choice is best--the traditional IRA or the Roth IRA. What do you think? --Naomi G.

Dear Naomi,

When you open your IRA, you'll be in plenty of good company. According to the Investment Company Institute, about 42 percent of U.S. households owned IRAs as of last year. The reason for their popularity is simple: IRAs offer terrific tax advantages that mean you keep significantly more of your money than if it was invested in a regular taxable account.

Your first step in IRA investing is to understand the key differences between the two major types of IRAs. The traditional IRA allows your money to grow tax-deferred until you withdraw it and, in some cases, lets you deduct your contribution. The Roth IRA, on the other hand, allows your money to grow tax-free, but you are never allowed a deduction for your contribution and can contribute only if your income does not exceed a set limit.

When we asked members of the Armchair Millionaire community which type they prefer, we got a range of responses:

Go for the Roth. "For me, hands down the best choice is the Roth. The reason is two of the greatest words ever put together in the English language: TAX FREE!" --Sean D.

Go for the traditional. "I love getting that tax deduction every year, so I always invest the maximum I can in my traditional IRA." --Seattle Sailor

Go for both. "I'm equally invested in both. My income fluctuates, so if I make more than the Roth limit, I invest in a traditional. If not, I invest in a Roth." --Josh L.

To help you decide which type is right for you, use my overview of IRA rules.

The Armchair Millionaire Checklist of IRA Rules

• Who can contribute. Traditional IRAs are available to anyone under age 70 1/2 who has any amount of earned income. If you participate in an employer retirement plan, your contribution may not be tax deductible, depending on your income. Roth IRAs are available to anyone earning less than $110,000 (for single filers) or $160,000 (married filing jointly).

• How much you can contribute. Both types let contribute up to a combined total of $3,000 for 2002. If you're age 50 or older, this amount is $3,500.

• When you can make withdrawals. In general, you'll have to pay a 10 percent penalty, plus taxes, if you withdraw money from a traditional IRA before age 59 1/2. For the Roth, you can withdraw your contributions at any time without penalty, but will have to pay the penalty and tax on withdrawals of your earnings if you're under 59 1/2 and have had the account open less than five years. There are some important exceptions that allow you to avoid these penalties for both types of IRAs, so be sure to check with a tax advisor before making withdrawals.

• When you must make withdrawals. You're required to start making withdrawals from (and paying taxes on) a traditional IRA by age 70 1/2. The Roth has no such requirement.

THE BOTTOM LINE: When it comes to choosing between a Roth IRA and a traditional IRA, don't ignore the forest because of the trees. The most important move is to begin and maintain any kind of long term savings plan. Either choice will help to ensure a long and fulfilling retirement.

How To Turn Your Tax Refund Into Half a Million Bucks

Question of the week: This year for the first time I'll be getting a very nice tax refund check-about $4,000. I'd really like to make the most of this unexpected windfall. What do you suggest I do with it? --Miami Taxpayer

Dear Miami,

We asked the members of the Armchair Millionaire community what they'll be doing with their refunds. Here's what they told us:

Start saving. "I'm receiving just over $1,000 back and am planning to finally get an emergency fund established." --Professor G.

Pay off debt. "My wife and I already received our tax refund of $4,149, which we have used to pay off our two car loans." --James B.

Spread it around. "I will be getting over $8,000 back this year and plan to equally divide it between investing for my children's education and refinishing my basement." --Gregor

Of course, the biggest bang of all from your tax refund check would be to put it to work in the stock market. If you invest your $4,000 in an index fund achieving the historical average annual return of about 11 percent, and then add another $2,000 to the account each year, it will grow to over $500,000 over the next 30 years. My checklist will guide you on this route.

The Armchair Millionaire Checklist for Sensible, Long-Term Investing

• Choose diverse, low cost investments. You want a balanced investment that will track the overall stock market. At the same time, you don't want to see your money drained away by high the high fees or loads that some mutual funds charge. To achieve both these goals, a no load index fund is your very best bet.

• Minimize your taxes. Taxes on your investment do nothing but drag down your overall returns, so take full advantage of tax-advantaged accounts. You can defer your taxes by using a traditional IRA, or steer clear of them altogether by using a Roth IRA.

• Reinvest all returns. Over time, you'll get the most growth in your portfolio from compounding returns, so be sure to have all interest and dividends automatically reinvested.

• Start now. Compounding returns need time to work, so give your portfolio as much as you possibly can. Don't delay in starting to invest.

THE BOTTOM LINE: Building a powerful portfolio doesn't require special genius or a huge amount to begin. All you need is a modest amount--like your tax refund--and the commitment to stick with a long-term plan. Get started now.