Father of 2 Should Pay Off Debt First, Even at Expense of Retirement Fund

In those blissful years B.C.--before children--Mario Ayala’s two focuses in life were work and play, with an emphasis on play. Thoughts of retirement, let alone saving for retirement, were as remote as Mars.

And then he became the unmarried, unplanned father of two. “Jasmine was born on my 30th birthday--that’s what slapped me in the face--and Adelina, my second daughter, she’s who woke me up,” said Ayala, now 36.

“Up until then I was playing, having fun, all carefree. I don’t know where I’d be if I was still doing that. My girls made me wake up and ask, ‘What are you going to be doing 20 years from now?’ Having children is a serious business, but it’s a good serious.”

Ayala’s focus today, besides his daughters, is becoming a knowledgeable investor and building a retirement fund as fast as he can from the $60,000 he grosses as a self-employed contractor. He loves the physical work of construction, “but I’m young now. I don’t want to be 75 years old and still out there working hard. Right now I’m gung-ho on life, and I want to be gung-ho in how I proceed in investing.”

How gung-ho? In less than three years, relying on advice from “wise friends,” he has saved nearly $11,000 in two retirement funds, a Roth IRA and a SEP-IRA. His savings grew so fast partly because he purchased 12 shares each of Microsoft and Intel last year and then sold them at a substantial profit. He’s currently socking $442 into the two IRAs every month.

But Ayala also has about $15,000 in debt, requiring $550 in monthly payments. And after deducting $800 for income taxes and $1,000 for child support, he often ends the month in the red, making ends meet with his credit card.

That’s why Ann Egan, an independent certified financial planner in Fountain Valley, thinks Ayala would do well to stop his retirement contributions for now and put the $442 toward paying off his debt and buying disability insurance. The latter is especially important, Egan said, because Ayala is self-employed in a relatively high-risk job and has no buffer savings.

“It’s hard for me to say this, because I’m so retirement oriented,” Egan said, “but if he can accelerate the payments on his debt, he’ll get rid of it in 18 months or so. He’s done a real good job so far, and if he can get beyond the short-term ugly, he’ll be in better shape than a lot of 36-year-olds.”

Beyond eliminating the debt payments, there isn’t much fat to cut in Ayala’s budget. His monthly expenses are relatively low--$495 for a studio apartment over a garage in the Fairfax District, $700 for the lease, gas and insurance on his pickup, $100 for tools for his business and about $200 for his cell phone, his only telephone. His wardrobe is mostly jeans, shorts and T-shirts and he carries sack lunches to work.

He doesn’t eat out much, he said, except when his daughters come to visit, and even then it’s nothing lavish. “I’ve scoped out all the deals, like breakfast at Norm’s for $1.99. For entertainment, I take them to the zoo for $5 or the Children’s Museum for $3. I usually find coupons and most of the time we spend in the park.”

Part of the $15,000 he owes came from nearly $10,000 in credit card debt. Early this year, his girlfriend gave him a $10,000 personal loan at 11% interest, much lower than his credit card rates, and he’s been paying that off at $400 a month. It’s down to $7,800 now.

The other big debt involved his former girlfriend, the mother of his children. Their breakup was followed by a custody battle and a court order that Ayala pay back the state about $7,500 in welfare the mother had collected during the dispute. He’s paying $150 a month on that debt now, plus $1,000 in child support. On the plus side, Ayala said, he gets to see his daughters every other weekend now with no hassles, and he’s on speaking terms again with their mother.

It’s often tempting for someone in Ayala’s position to consider using his retirement savings to pay off debts, even though there can be tax penalties on withdrawals. Indeed, another financial planner, Lewis Wallensky of Century City, recommended that Ayala at least take back the $1,670 he has contributed to his Roth IRA this year, because he can do so without penalty and use that to pay down his debt. Wallensky sees the Roth as a luxury Ayala can’t afford now.

“I would rather see someone build up some personal liquidity prior to putting their money into a Roth for the future,” Wallensky said. “What happens if he loses his job? He’s in deep doo-doo.”

Although Egan suggested that Ayala redirect his retirement saving to debt reduction, she advised against taking out any money already in IRAs. “That’s the only thing he’s got going for himself right now,” Egan said. “If he left that money there until he was 65 and never contributed another nickel to it, it should still be $200,000 by the time he’s ready to retire.”

The conflicting advice on the 1999 Roth IRA contribution reflects different approaches to the psychology of saving.

On paper, Wallensky’s suggestion makes more financial sense. Paying off debt that now costs 11% to 18% is equivalent to earning a guaranteed 11% to 18% tax-free return.

In Ayala’s case, the $1,670 in the Roth would save him about $250 in interest payments if it were used for debt reduction. Would that money earn more if it stayed invested? It’s uncertain. The stock market’s performance is not guaranteed and matches such returns only in exceptional years.

But Egan emphasized that retirement savings should be sacrosanct, a top priority regardless of what else is happening in an individual’s life. Tapping such savings should be reserved for only the most extreme emergencies. Some people need to take a disciplined approach to ensure they keep saving.

Also, Ayala can’t make up that Roth contribution later, and if his earnings rise he may no longer be eligible. Current federal rules limit Roth contributions to $2,000 annually and individuals or couples who earn more than $100,000 in adjusted gross income cannot contribute at all.

Egan figures that Ayala’s debt is manageable. If he takes $200 of the $442 he’s putting into his IRAs every month and adds that to his debt payments, he’ll have the $15,000 paid off in about 20 months. Egan advises that he use the rest of the money for disability insurance, which he should obtain even if he is routinely covered by workers’ compensation insurance at work. Such extra coverage may be expensive and difficult to find for an independent contractor, but it is worth the effort, she said.

In Ayala’s case, disability insurance has to be a priority, even over retirement savings, Egan said, “because you are your sole provider, period, and the main provider for your little girls. We always think about our assets in terms of what money we have, or whether we own a house, but really, our greatest asset is our ability to earn a living.”

Egan also noted that Ayala may want to fund a Roth IRA in future years, even if he doesn’t maximize the tax-deferred contributions in the SEP-IRA (or simplified employee pension). This runs counter to the conventional wisdom of funding a Roth after exhausting all tax-deferral possibilities.

The major reason is that Ayala expects to find himself at a higher tax bracket later in life, which makes a Roth IRA relatively more attractive. A Roth IRA is funded by “after tax” contributions, but there are no income taxes on it when money is withdrawn in retirement. The SEP-IRA, like a 401(k) or traditional IRA, is funded with “pretax” contributions and money withdrawn from such accounts is taxable. The SEP-IRA allows self-employed individuals to contribute up to 15% of their Schedule C income to an IRA.

Like Egan, Ayala believes the advantages of the Roth make it worth its delayed gratification, because he expects his construction business to grow and become more profitable by the time he retires.

Egan questions the conventional wisdom about Roths. “It always irritates me when people say the tax benefit when you retire doesn’t make much difference because you’ll be making a lot less money. Well, my theory is, I don’t want to make less when I retire. I want to have the same as when I was working, so therefore the benefit of tax-free is as important as when I’m working,” Egan said. Ayala has “the ability to pay the taxes now, so I lean toward the direction of saying, when you’re old, you’d rather not have the tax liability.”

Egan noted that Ayala might have been a little rash when he recently moved his Roth IRA out of Oppenheimer funds and his SEP-IRA out of the Van Kampen funds and put them both into the Fidelity Group of funds on the advice of his friends.

In general, Egan said, if a fund is not performing well, it’s better to look at other funds within the group before jumping into a new fund group. With Ayala’s IRA, for instance, “he was in a perfectly good fund family and he took a punishment [in back-end fees] to move out. He could have looked around in that fund family and found other excellent positions. Sometimes people make decisions too rapidly, without looking at all their options.”

Now that he’s made the move, however, Egan recommended that Ayala consider Fidelity’s aggressive growth funds. “Fidelity has lots of growth funds, and they do have very good funds, so find something labeled aggressive growth with a decent track record and then just leave it alone,” she said. “Don’t try to time the market on this because . . . the market will go up and down a zillion times before you’re 65.

“If you were 56 and starting out, you’d have to be a little more conservative because you don’t have time to re-earn the money [if the market drops], but at 36 you do. Nobody invests with the idea they’re going to lose it, but we all know that markets go up and down.”

And how should Ayala choose his funds? He can do the research himself, she said, if he has the time and interest. “It’s not rocket science. . . . If you’re computer savvy and have access to the Internet, you can check the mutual fund rating services like Morningstar and Standard & Poor’s.”

Also, much is published in books, newspapers and magazines aimed at helping individuals manage their own investments. Or Ayala could work with a broker or financial planner while still educating himself--although only a handful of planners are willing to work on an hourly or occasional basis.

Ayala said he has talked to advisors but felt intimidated. “It was almost like I bothered them by calling, because I didn’t have enough money to invest.”

“You know what you do with those people? You get off the phone,” Egan said. “There are more people in the world who make $60,000 and under than make $60,000 and over, and you need to find someone who will work with you and understand your objectives. Your $100 is just as important as the next guy’s $100,000. That’s your future and you’ve got to protect it and feel good about it.”

Egan said there are many advisors who work with small investors. “Some work on a consulting basis and charge hourly and some don’t assess a fee--they just tell you to purchase a loaded mutual fund and you pay a commission . . . when you buy it.” Among the ways to learn about financial planners, Egan said, is the Web site of the International Assn. of Financial Planning, at https://www.iafp.org (follow the “Consumers click here” link).

Regardless of how Ayala decides to invest, the important thing is continuing to save, Egan emphasized.

“I always figure for most people there’s at least $25 a month somewhere in their budget that they can be putting away, and that’s not too small an amount,” she said. “I’d rather see people put away something, no matter how small, than do nothing.”

Jeanette Marantos is a regular contributor to The Times. To be considered for 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 or to money@latimes.com. You can save a step and print or download the questionnaire at http://161.35.110.226/makeoverform.

Information on choosing a financial planner is available at The Times’ Web site at http://161.35.110.226/finplan. The site offers stories, phone numbers, addresses and links to related sites.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

This Week’s Make-Over

* Investor: Mario Ayala, 36, single, with two daughters who live with their mother

* Annual income: $60,000

Goals

* Immediate: Eliminate debt and learn how to become an aggressive investor.

* Long-term: Build a hefty retirement fund.

Current Portfolio

* Assets: $11,000, divided between Roth IRA and SEP-IRA

* Debts: $7,800 in personal loan; $7,500 in welfare arrears; also pays $1,000 a month in child support

Recommendations

* Stop contributions to IRAs for now, pay off debt more rapidly.

* Purchase disability insurance.

* Start building a rainy-day savings fund.

n Move IRAs out of money-market accounts into aggressive growth mutual funds.

n Set aside time for regular research and investment education.

About the Planner

Ann Egan is a certified financial planner and investment advisor with Vision Capital Advisers in Fountain Valley. She has spent two decades in financial planning positions.