Top 5—investing moves when you’re just getting started

A week ago, my Uncle Lynx passed away.  At the funeral I was chatting with some distant family members (my cousin’s wife’s nephew).  He and his wife are a super cute couple.  They are in their early 20s and just getting started on this crazy journey called adulthood.

As we were chatting, the subject veered towards personal finance (me talking about personal finance . . . imagine that).  This couple’s ears perked up and then seemed genuinely interested; I suppose it’s possible they were just really polite, but I think it was something more.

It got me to thinking about what are the most important things to do in the world of personal finance when you are just getting started.  Here is my Top 5 list:

 

5. Figure out your debt situation: If you’re lucky, you won’t have a lot (or any) debt.  For most of us there is some out there, and that isn’t necessarily a bad thing.  List out every debt you have (student loan, mortgage, credit card, car payment, etc.), the balance, and the interest rate.

On a spreadsheet (see #4) rank them in order of interest rate.  As a general rule I use a cutoff of about 6%.  If your interest rate is above that pay those off right away, starting with the highest interest rate debt first.  If your interest rate is below that, that might be okay to keep that debt and just make the normal monthly payments.

If you have any debt (especially credit card debt) at any rate higher than 10%, that’s a “debt emergency”.  Really look at every purchase you make—if it’s not critical to your survival (food, shelter) then pass that up until your debt is paid off.  The only exception to this is #1—funding your 401k.

You can get creative with your debt by consolidating high interest rate cards onto a lower rate card or one that offers a low teaser rate.  That could save you a ton of money, and you should probably look into that, but ultimately, you’ll need to pay that sucker off.  So just hitting the grindstone of paying off your credit cards is a must.

 

4. Make a budget on a spreadsheet: Take a spreadsheet and put a quick budget together that includes your income, your expenses, and the difference between those two.  This can be simple at first (and it should be simple at first).  Over time, you’ll add more and more sheets to the spreadsheet for things like your mortgage, investments, kids’ education, and other things.

But at the beginning, you need to get a sense of where your money is going.  The budget will give you an aspirational view of this.  After your budget is done, you can track your spending with a website like mint.com.  This two-step process lets you figure where you want to spend your money, and then also look at where you actually spend it.

Of course, this is an iterative process, and as you close a month and look at your expenses, you can see if you’re spending more than what you budgeted.  This isn’t a time to beat yourself up (being too hard on yourself is a sure way to stop looking at your finances closely, and that’s a REALLY bad thing), but a time to ask yourself why you spent more and if it was worth it.

As an aside, using a spreadsheet is a really good skill in general.  I was really good at spreadsheets and it’s hard to overstate the incredible impact it had on my career, as well as the incredible wealth those skills gave me and my family.  And really, my experience with spreadsheets started in college when I was creating a financial budget.

 

3. Educate yourself on investing: At a young age, educate yourself on investing.  Obviously, this blog is the universally acknowledged best place to learn about investing, but I have heard rumors there are others.

www.mrmoneymustache.com is a great website that looks at personal spending and his early posts had a tremendous impact on my outlook.  A Random Walk Down Wall Street is a book on investing that really defined my investing strategy; I read that as a 19-year-old and still think about its insights today.

There are a lot of websites written by millennials about spending and personal finance that might resonate even more.  A few are: millennialmoneyman.com, moneypeach.com, and brokemillennial.com.  Most are about reducing spending and budgets and that sort of thing, but there are some on the nitty gritty of making investing choices.  You’ll want perspectives on both.

The whole point is that you need to know what you are doing here.  Spending 20 hours early in your life to figure out basics like asset allocation, tax avoidance, and fee minimization as well as a general attitude towards saving early can easily lead to hundreds of thousands or millions of dollars.  That comes to about $50,000 per hour—not bad.

 

2. Start an IRA with $1,000: This is as much about the experience gained as it is about actually investing your money.  Vanguard lets you start an IRA with $1,000 as the minimum amount.

You’ll navigate through their website, figure out how to make choices (like Roth or Traditional IRA—go traditional).  You’ll pick your investments, and then you’ll have something to look at every once in a while to see how it’s doing.

So many people are just at a total loss when it comes to setting up accounts for their investments.  That becomes a real problem once you hit 30 or 40 and you’re starting to get behind the 8-ball; you know you need to do something but are kind of clueless on where to start.  Doing it now lets you get your toes wet in this world and makes the next accounts you need to set up (529, 401k, brokerage, etc.) all the less daunting.

 

1. Get the company match on your 401k: #2 was more for experience than for investment.  Here is where you should start walking down the path for investments.  At a minimum, contribute the match and take the free money.

This is so important for a couple reasons.  First, you’re getting that free money.  Second, you’re making your first “asset allocation” decision.  When it comes time to pick which fund to invest in, unless you have very unique circumstances for an early-20s person, I would definitely go with a 100% equity index fund.

Third, your 401k is a really powerful tool.  If you had no other investing tool, you could still grow a 401k to well over a $1 million during your working career.  That is enough to fully fund your retirement.

 

BONUS—Stay poor:  Too many young adults make a huge mistake of trying to mimic the lifestyle their parents provided, once they (the young adults) get out of school.  That first paycheck of $2,000 is going to seem like a ton of money (and it is).  It’s really tempting to decide to buy a new car or go on a kickin’ vacation or upgrade the furniture.  Resist the urge.

Your parents took 25 or more years of working (with pay increases and investment returns) to provide the house and cars and vacations you enjoyed your senior year of high school.  It’s not realistic to think you can have stuff at that level of niceness so early.

A car is a really good example.  In general, automobiles are horrible investments.  To the degree you have a car that can get you from point A to point B, keep it.  A new car will be nice and cool and make your friends gawk, but it’s a horrible use of money.  A couple hundred dollars a month for a car, plus insurance, and maybe $50 for a gym membership, $50 for cable, and $80 for four dinners at a restaurant—those numbers add up.  Those alone could fund your savings in the early years.

Your early 20s are a time when it’s still okay not to have the best and nicest of everything.  If you can embrace that, even when you do have the money, and put that extra money to work in investments you’ll build a very strong financial foundation that will afford you many more opportunities are you reach your 30s and 40s (remember, I did that and I retired at 36).

The tax man cometh

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

 

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my old neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends.  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).

To Roth or not to Roth

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As you enter the world of investing, one of the first decisions you need to make it whether to open a Traditional IRA or a Roth IRA.  Of course, I’m taking for granted that you’re using an IRA to save money, because we know that being smart with taxes is one of the most important things you can do.  As you read this, remember that I’m not a tax expert, but here is how I look at this issue.

These IRA cousins are both tax advantaged, but they go about it in different ways.  With a Traditional IRA, you are allowed deduct your contribution from your taxes that year; however you pay taxes on the money when you withdraw it in retirement.  Conversely, with a Roth IRA you contribute with after-tax dollars but then when you withdraw the money in retirement it’s tax free.

So basically with Traditional and Roth IRAs, you’re making a choice between paying taxes now or later.  If you lived in a world where your tax rate didn’t change over time, there would be no financial implications in the choice between the two IRA types.  The math would work out the exact same.  However, we don’t live in that world.  We live in a world where your tax rate goes up the more money you make.  In this world, we want to pay taxes when our tax rate is at its lowest.  So where does that leave us?

I did some quick estimates of what someone’s marginal tax rate would be in a high tax state (California—where the Foxes used to live) and a low tax state like Florida.  I did this at three different income levels: $50,000 (when you’re just starting out), $100,000 (after you’ve been working for a while), and $20,000 (when you’re in retirement—remember you’ll spend more than that but only $20k will be taxed as income).

MARGINAL TAX RATES

High-tax state

Low-tax state

$50,000 (early working career)

33%

25%

$100,000 (later working career)

37%

28%

$20,000 (retirement)

17%

15%

 

Wow!!!  Look at that.   We all knew that we would have the highest tax rate when our income peaked.  But did we really expect that we’d be paying double the tax rate when we were starting out compared to when we were retired?  That’s a huge difference.

Now, remember that the major difference between a Traditional IRA and a Roth is when you pay your taxes.  For a Traditional IRA, you’re getting a deduction while you’re working so that $5000 you contribute in your early years gives you a $1667 tax deduction ($5000 x 33% tax rate), and a $1850 deduction ($5000 x 37% tax rate) in your middle years.  Of course you’ll have to pay taxes on that money when you retire, which would be about $850 ($5000 x 17%).  Compare that to a Roth IRA where you’re paying taxes on that $5000 during your early years ($1667) and your middle years ($1850) in order to avoid paying taxes in retirement ($850).

In a world where we want to maximize our portfolio by minimizing our taxes (legally, of course), the answer seems clear—GO WITH A TRADITIONAL IRA.  The back of the envelop math says that going with a Traditional IRA will save you about $1000 per year that you contribute.  Remember that $1000 per year over a working career of 40 years, adds up to about $150,000.  Those are pretty high stakes for what seems like a pretty innocuous choice.

So why do so many people instead go with a Roth IRA?  Why did Stocky Fox himself open up a Roth IRA instead of a Traditional IRA?

  • Don’t understand rules: A major culprit is that many investors don’t understand the tax rules all that well.  Because of that they don’t have a strong opinion on which type of IRA to pick so they go with the one that others tell them is better (which leads to the next reason).
  • Roth IRAs are marketed better: For some reason it seems that Roth IRAs are marketed better than Traditional IRAs.  I don’t know if it’s because “Roth” sounds like an actual name and that draws investors, or what.  But my experience tells me that the average investor would pick a Roth just because that “feels right”.
  • Uncertain tax future: As my loyal readers Mike and Rich have pointed out in the past, the future tax rates are uncertain.  Today we know that a current tax rates make a Traditional IRA a better option, but what if those tax rates change in the future?  It could definitely impact the decision, but who really knows what will happen?  If I could predict the future I would own my own Caribbean island.
  • Get the pain done with: As a kid I used to eat cupcakes upside down; start with the cake and finish with the best part, the frosting.  Some use my cupcake strategy to get the “hard part” over and done with; they choose a Roth IRA because they get the taxes out of the way and then it’s smooth sailing.  This is following your heart instead of your head which may not make sense financially but we all do it.
  • Bad advice: You’ve heard me rail about investment advisers who maybe aren’t all that good.  A lot of people might take advice on which IRA to choose from someone who really hasn’t done the analysis, so they say “yeah, go with the Roth.  Just as good as any.”

I’m sure there are many more reasons but that’s my list.  At the end of the day I think Traditional IRAs are the best choice for most people just because with them, when you do finally pay taxes in retirement you’re probably paying at a lower rate than any time during your working career.  And that choice can be of the six-digit variety.  Yikes!!!

Of course, you there are special circumstances where maybe a Roth IRA works better.  Maybe you’re a kid with really low income (less than $10,000 like from a summer job), but those are probably more the exception.

 

Let me know what you think in the comments section.

How much should I save during my working years?

Monday we started tacking the enormous question of “How much do I need to retire?”  We dove into the first sub-question:  How much will I spend in retirement?  Now we’re going to take on the next question: How much should I save during my working years?  Then tomorrow we’ll bring it all together by answering the third question: When can I retire?

 

Let’s start talking about savings.  We know that savings is the fundamental ingredient in investing and we know that starting early provides a great advantage.  We’re going to use the example of my cousin, Skinny Fox.  Skinny is 22 years old, just starting out with a $50,000 per year job.  She expects salary increases of 5% (a little more than inflation) and she’ll eventually top out at a salary of $150,000 per year (in future dollars).

 

Social Security

The first place to start when thinking about your nestegg is Social Security.  That’s the “forced” savings plan the US government makes you do.  It’s complex and there is a lot of nuance, but basically they’ll take 6.2% of Skinny’s income (plus another 6.2% from Skinny’s employer) over her working career.  When it’s time to hang up the spurs, she’ll get a monthly pension.  So in a very real way, Social Security is your first “savings” method.

Unfortunately, the rules for Social Security aren’t very straight-forward when it comes to figuring out how much you’ll get based on how much you put in.  However, it seems reasonable that a middle-class fox like Skinny will get a middle-class payout from Social Security like $2,000 (in today’s dollars) per month starting when she turns 67.

For Social Security, when Skinny “saves” her 6.2% of income ($3,100 in her first year of work), that gives her a pension that will be worth about $450,000 in today’s dollars; that’s about $1.6 million when Skinny turns 67.

 

401k

When Skinny Fox was looking for her job she knew how important it was to consider the company’s benefits beyond just the salary.  Her company offers a 401k and matches $0.50 for every dollar up to 6% of her salary.  Skinny knows she should max out her 401k because of tax reasons, but that’s just not realistic for her, so she just contributes the 6% to get her company match.

Her first year she contributes $3,000 to her 401k and her company kicks in a $1,500 match.  Over her entire career her 401k will steadily build until she turns 67 and it’s worth about $1.9 million (in future dollars)!!!

 

IRA and other savings

Skinny is a nervous soul whose father fox always taught her to save, save, save.  She knows that she can contribute to an IRA, after reading this blog she knows it should be a traditional IRA and not a Roth, with $5,000 per year.

When Skinny turns 65, that IRA is worth about $1.2 million.

If she’s still nervous, she can save in a regular brokerage account that doesn’t have the tax advantages of a 401k or IRA.  Each $1,000 per year she saves equates to about $200,000 when she turns 65.

 

This really illustrates the power of compounding.  I’m not saying that $3,000 per year for her 401k or $5,000 annually for her IRA isn’t a lot of money.  Especially when she’s first starting out—it’s definitely a lot.  But $8,000 doesn’t seem insurmountably unrealistic for Skinny.  Each year after that it gets a little easier.

However, the payoff seems huge.  Slowly and steadily, over her 43-year working career, her 401k will have steadily grown to $1.9 million and her IRA to $1.2 million.  She’ll also have a backstop of Social Security which would have a lump-sum value of about $1.6 million.  Combine all those, and she’s got a nest egg of about $4.7 million in future dollars (about $1.3 million in today’s dollars).

That certainly seems like a lot, but is it enough?  We know from yesterday’s post that $1.1-1.6 million is right in the range of a pretty decent retirement.  So Skinny’s there just based on her 401k, IRA, and Social Security.  The good news is that doesn’t include any home equity she builds over her adult life, extra savings just from making more than she spends, or any inheritances or other unexpected windfalls.  So maybe there’s some cushion there.

On the other hand, she maybe she shouldn’t feel especially comfortable.  She has a clear path to $1.3 million and she’ll need $1.1-1.6 million.  That’s definitely within the margin of error.  What is a vixen to do?

Come back next Monday for our final installment of this blog mini-series where we bring together what you’re going to spend in retirement with how much you have saved for retirement, and we’ll see if it all works.

I screwed myself by rolling over my 401k

rollover-ira

Kind of, but not really.  I wanted to put a dramatic headline up to see if that would drive more traffic.  However, I did lose a little bit of money by rolling over my 401k from Medtronic into my IRA with Vanguard.  Here’s my story:

 

As you know, I left my job at Medtronic a while back.  Whenever you leave a job, there’s actually a lot of work involved with your finances.  You have to move them from the accounts set up by your company, to your own individual accounts.  Best case is it’s a pain in the butt; worst case is you can forget about some of it and lose it forever.  So it’s an important process.

So when I left Medtronic I knew I had to take my 401k account and roll it over into an IRA.  But there wasn’t a lot of urgency because Medtronic had their 401k at Vanguard, and all our other accounts are at Vanguard, so it seemed fine.  But then the Medtronic/Covidien merger happened, and as part of that, Medtronic switched from Vanguard to Aon Hewitt.  I wanted to keep all my money in one place for convenience sake, so I called Aon and initiated the rollover.

For those who have never done it, it’s a pretty simple process.  You set up an IRA account where you want the money to go (Vanguard in my case).  They’ll ask you how you want to fund the IRA and you click on a choice that says something like “Rollover”.  Then you call up the place where you’re money is at (Aon in this case) and start the process.  Usually they’ll send you a check which YOU DO NOT CASH, but instead just send it on to Vanguard.  Overall the process takes about two weeks.

But that two weeks is what screwed me a little bit.  During those two weeks your money is not in the market.  As you know from many posts I have done, the stock market is really unpredictable in the short-term, so it’s impossible to time the rollover process to your advantage.  Ideally, that two week process would coincide with a brief downturn in the market.  Conversely, you hope that two week period isn’t when the market stages a blazing recovery.

Based on the title of this post, you can probably guess what the case was for me.  As we know, the first few weeks of the year were really bad for stocks, and then they started a slow recovery.  If I could predict the future, that would have been the time to do my rollover, at the beginning of the year right before stocks fell 10% over the course of a couple weeks.  Of course, if I could predict the future, I would own my own island in the Caribbean.

I took the plunge in mid-February, and as you can see, stocks started inching up.  It was a perverse feeling: of course I like when stocks go up because we have so much invested in stocks.  But on the other hand, I felt that part of my portfolio was missing out on those gains.  Following the stock market too closely can really mess with your head.  Anyway, after a week, I got my check from Aon, which I promptly sent to Vanguard.  In that week, stocks were up about 0.8%.  My 401k from Aon was worth about $140,000, so missing out on that 0.8% gain cost me about $1100.

Once I put the check in the mail to Vanguard, the investing gods decided I needed to be further humbled, so in the next week stocks went on a major tear, rising about 3.2%.  Of all the times, why then?  My being out of the market for that week cost me another $4400.

Roll over IRA

Add that up and you’re talking a decent chunk of change.  My timing for doing the rollover couldn’t have been worse, and in the end I missed out on about $5500 in market gains.  That sucks.

But you win some and you lose some.  I am sure that I have come out ahead some of the other times I’ve transferred accounts, but as Matt Damon’s character said in Rounders: you tend to remember your spectacular loses more than your amazing wins.  Just human nature I guess.

That said, there’s definitely a lesson there, which is you need to stay in the market.  As we have discussed ad naseum, the market is very unpredictable in the short term often times with wild swings.  But over the long term it has a relentless upward march.  I had to get out of the market for a pretty unavoidable reason, so maybe I get a pass.  But what about those people who got spooked by the January plunge and then missed out on the February recovery?  They got crushed and could have really hurt their financial plan.

 

So there you go.  I hope you were entertained by my misfortune.

What to make of pensions

pension

Medtronic is such an amazing company, for so many reasons.  Beyond that whole “create amazing medical products that help people live healthier, fuller lives,” they offer some incredible financial benefits to their employees to help them build a comfortable financial future.

One benefit in particular is they give each employee and extra 5% of their pay which they set aside in a pension account.  When you leave the company, they give you that money either in a lump-sum or they will give you a pension for the rest of your life.  It’s an awesome benefit, but it involves a difficult choice: do you take the lump sum or do you take the pension?  Here is how I made that choice, and the different factors I took into account.

 

When I left Medtronic, my pension account had about $50,000 in it.  Medtronic could give me that in the form of a lump sum, or, based on my age (38 years old), they would give me a monthly pension of $220 until my death.  So which one did I pick?  Which one would you pick?

 

The case for taking the lump sum

  1. There’s something to be said for getting the cash all up front. Those monthly pension payments come only so long as Medtronic is able to pay them.  Right now they are an extremely strong company financially, but we’ve seen many times how strong companies can fall on hard times and lose their way.  This is especially true after major mergers (Time Warner with AOL, Boston Scientific with Guidant, etc.) and Medtronic did just merge with Covidien.  I have absolute faith that Medtronic will be able to pay me, but if you get the money up front, that’s one less thing to worry about.
  2. When you get the money, it is usually rolled over into an IRA so you don’t pay taxes on it (if you take it in actual cash, there are major penalties similar to if you cashed out your 401k). So you aren’t paying taxes on the money when you’re younger and you’re probably in a higher income bracket.
  3. The biggie is that you get to invest that money and then have it available when you turn 60. For me that’s a 22 year time horizon so I could invest it pretty aggressively in the stock market knowing that over that long of a time the probability is extremely high that the money will grow a lot.  Just using some basic assumptions, that $50,000 would probably be worth about $180,000 when I turn 60.

 

The case for taking the monthly pension

  1. You can use the monthly pension for today’s expenses. $220 isn’t a ton, but it’s still a nice chunk of change.  Just looking at our budget, that could pay for our internet, cable, and car insurance.  That’s not bad.  Basically I’ll have those “free” for the rest of my life.
  2. A pension is a nice way to diversify. As I mentioned here, most of our savings is in stocks which is appropriate given our ages and personal situation.  We have very little in bonds and other safer investments, so having a pension fills a little bit of a gap we have.
  3. When faced with the choice of taking a pension for $220 per month or getting a lump sum of $50,000, the pension is the better deal. If you shopped around for an annuity a 38-year-old male could get a $220 per month, and it would cost about $55,000.  So basically by picking the pension option from Medtronic I’m getting an extra 10% compared to what it would cost me to buy it in the open market.

 

There are good reasons to go either way.  Foxy Lady and I struggled with this a lot.  For us, it was a choice of going with your head (you’d choose the lump sum) or your heart (you’d choose the pension).

Financially, it’s a much better option going with the lump sum because you can invest it and let it grow.  When we’re 60 we could take all that money and buy an annuity worth $720 a month.  Given that Foxy Lady and I don’t need the income right now because she’s working and I’ve found a little bit of work on the side, it’s a better deal to take the bigger number when we do stop working.

But the heart wants what it wants.  There’s something comforting about getting a tiny income stream now that you know will always be there.  It’s not dependent upon the stock market or anything, and if everything did go to hell with the stock market in some catastrophic way, we would have this little bit.  Plus, as I mentioned earlier, we have a nice little nestegg right now but it’s all invested in stocks.  This provides a little bit of fixed-income diversification.  For these reason, we ultimately decided to go with the pension.

So there you go, a nice little primer on how to pick between a lump sum and a pension.  What do you think?  Would you have made the same choice?  If you’re with Medtronic, what are your thoughts on the matter?

To Roth or not to Roth

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As you enter the world of investing, one of the first decisions you need to make it whether to open a Traditional IRA or a Roth IRA.  Of course, I’m taking for granted that you’re using an IRA to save money, because we know that being smart with taxes is one of the most important things you can do.  As you read this, remember that I’m not a tax expert, but here is how I look at this issue.

These IRA cousins are both tax advantaged, but they go about it in different ways.  With a Traditional IRA, you are allowed deduct your contribution from your taxes that year; however you pay taxes on the money when you withdraw it in retirement.  Conversely, with a Roth IRA you contribute with after-tax dollars but then when you withdraw the money in retirement it’s tax free.

So basically with Traditional and Roth IRAs, you’re making a choice between paying taxes now or later.  If you lived in a world where your tax rate didn’t change over time, there would be no financial implications in the choice between the two IRA types.  The math would work out the exact same.  However, we don’t live in that world.  We live in a world where your tax rate goes up the more money you make.  In this world, we want to pay taxes when our tax rate is at its lowest.  So where does that leave us?

I did some quick estimates of what someone’s marginal tax rate would be in a high tax state (California—where the Foxes live) and a low tax state like Florida.  I did this at three different income levels: $50,000 (when you’re just starting out), $100,000 (after you’ve been working for a while), and $20,000 (when you’re in retirement—remember you’ll spend more than that but only $20k will be taxed as income).

MARGINAL TAX RATES

High-tax state

Low-tax state

$50,000 (early working career)

33%

25%

$100,000 (later working career)

37%

28%

$20,000 (retirement)

17%

15%

 

Wow!!!  Look at that.   We all knew that we would have the highest tax rate when our income peaked.  But did we really expect that we’d be paying double the tax rate when we were starting out compared to when we were retired?  That’s a huge difference.

Now, remember that the major difference between a Traditional IRA and a Roth is when you pay your taxes.  For a Traditional IRA, you’re getting a deduction while you’re working so that $5000 you contribute in your early years gives you a $1667 tax deduction ($5000 x 33% tax rate), and a $1850 deduction ($5000 x 37% tax rate) in your middle years.  Of course you’ll have to pay taxes on that money when you retire, which would be about $850 ($5000 x 17%).  Compare that to a Roth IRA where you’re paying taxes on that $5000 during your early years ($1667) and your middle years ($1850) in order to avoid paying taxes in retirement ($850).

In a world where we want to maximize our portfolio by minimizing our taxes (legally, of course), the answer seems clear—GO WITH A TRADITIONAL IRA.  The back of the envelop math says that going with a Traditional IRA will save you about $1000 per year that you contribute.  Remember that $1000 per year over a working career of 40 years, adds up to about $150,000.  Those are pretty high stakes for what seems like a pretty innocuous choice.

So why do so many people instead go with a Roth IRA?  Why did Stocky Fox himself open up a Roth IRA instead of a Traditional IRA?

  • Don’t understand rules: A major culprit is that many investors don’t understand the tax rules all that well.  Because of that they don’t have a strong opinion on which type of IRA to pick so they go with the one that others tell them is better (which leads to the next reason).
  • Roth IRAs are marketed better: For some reason it seems that Roth IRAs are marketed better than Traditional IRAs.  I don’t know if it’s because “Roth” sounds like an actual name and that draws investors, or what.  But my experience tells me that the average investor would pick a Roth just because that “feels right”.
  • Uncertain tax future: As my loyal readers Mike and Rich have pointed out in the past, the future tax rates are uncertain.  Today we know that a current tax rates make a Traditional IRA a better option, but what if those tax rates change in the future?  It could definitely impact the decision, but who really knows what will happen?  If I could predict the future I would own my own Caribbean island next to Johnny Depp.
  • Get the pain done with: As a kid I used to eat cupcakes upside down; start with the cake and finish with the best part, the frosting.  Some use my cupcake strategy to get the “hard part” over and done with.  They choose a Roth IRA because they get the taxes out of the way and then it’s smooth sailing.  This is following your heart instead of your head which may not make sense financially but we all do it.
  • Bad advice: You’ve heard me rail about investment advisers who maybe aren’t all that good.  A lot of people might take advice on which IRA to choose from someone who really hasn’t done the analysis, so they say “yeah, go with the Roth.  Just as good as any.”

I’m sure there are many more reasons but that’s my list.  At the end of the day I think Traditional IRAs are the best choice for most people just because with them, when you do finally pay taxes in retirement you’re probably paying at a lower rate than any time during your working career.  And that choice can be of the six-digit variety.  Yikes!!!

Of course, you there are special circumstances where maybe a Roth IRA works better.  Maybe you’re a kid with really low income (less than $10,000 like from a summer job), but those are probably more the exception.

 

Let me know what you think in the comments section.

 

 

The power of a single percentage

2014-02-18 (1 percent)

“How can something so small be so impressive?” –Belinda Heggen

1% doesn’t seem like a lot.  It’s the extra sales tax my city adds, hoping I don’t notice it.  It’s the maximum amount of gross stuff food companies can put in packaged food without having to tell us (I don’t know it that’s true or not).  But in investing 1%, while so easy to overlook, can make a huge difference.  Here we’re going to find out how we can get that 1% to help us.

Let’s go back to my neighbors, Mr and Mrs Grizzly.  Each year they will save $10,000, investing it in a stock index mutual fund with an expected annual return of 6%.  After 30 years, they expect to have $790,581 saved (good time for the disclaimer that I am not predicting future stock performance, just giving an example), a tidy little sum to help see them through their golden years.

However, Mrs Grizzly starts playing with her spreadsheet and changes the annual return from 6% to 7% just to see what happens.  She’s astounded to see that the $790,581 that she gets with a 6% return balloons to $944,608 if she assumes a 7% return; that increase in the annual return of 1% led to an increase in her nest egg of 19%.  Tempting fate she sees what happens with an 8% return: $1,132,832.  She’s a millionaire now.  Cranking the return up to 9% made her nest egg $1,363,075; just increasing her return 3% nearly doubles how much she and Mr Grizzly will have to retire on.  Ladies and gentlemen, welcome to the power of compound interest!!!

Percentage graphic

The point here is that a seemingly small 1% change in your investment return can make a huge difference over time.  By tailoring your investment strategies to collect as many “1% coupons” as possible, you can substantially increase, even double, the value of your nest egg.

So how do we get those higher returns?  Most people will default to higher stock returns: “It’s a no-brainer.  Instead of investing in the stocks and mutual funds that return 6%, let’s invest in the ones that return 7%.”  Unfortunately, after reading A Random Walk Down Wall Street we know this isn’t so easy.  For any given level of risk, our investment return is probably going to be what it will be.

Now that changing the actual investment return is out, what are our options?  Fortunately there are a lot of other things that affect our total return beyond just what our investments give us.  We’ll dive into each one of these with its own blog post, but a few to think about at a high level are:

  1. Mutual fund management fees: Each year mutual funds charge between 0.05% all the way up to 1.50% or more for management fees.  Going from high-cost mutual funds to low-cost funds can easily get us a 1% coupon.
  2. Financial planner fees: There are a lot of people out there who are more than willing to tell you how to invest your money for a small fee.  Except that fee doesn’t tend to be all that small: about 1-2% of your total assets.  Do-it-yourself investing can absolutely give you that 1% coupon, and the results you produce will probably be similar to those your investment adviser would.
  3. Being smart with taxes: You know Uncle Sam is going to take his cut.  However, you can delay when he takes his share with IRAs, 401k’s, etc.  This allows you to keep the money longer, and it allows to you be taxed on the money later in your life when you will probably be in a lower tax bracket.  Being smart with your taxes can easily get you a 1% coupon.
  4. Take the “free money” offered to you: Many of us work for companies that match 401k contributions.  Except they only give you the extra money if you invest in your 401k.  So at least putting in up the minimum amount of get the match can absolutely give you one or two 1% coupons.
  5. Proper asset allocation: We all know that some of your investments should be in higher return, riskier investments like stocks and some should be in lower return, less risky investments like bonds.  Properly assessing your portfolio to know how much you already have in less risky investments (especially things like pensions, Social Security, your home equity, etc.), can allow you to safely put more money in investments like stocks.  Over the long term, this could easily increase your return each year and get you a 1% coupon.
  6. Fully investing: So many people I talk to have $10,000 or $20,000 or $50,000 in their checking account that they’re “just waiting to figure out what to do with it.”  These are certainly Champagne problems, but they are also fertile ground to find 1% coupons.  Just taking that money and putting it in a bond fund instead of a checking or money market account could easily give that extra 1% or more; investing in a stock fund will provide even greater returns over the long run.

Those are just a few examples of how you can squeeze an extra 1% or more from your investment returns.  You’ll notice that none of those strategies include “outsmart Wall Street and pick the stocks that are going to do the best.”  I’m not that smart; I wish I was because then the Fox family would own its own island in the Caribbean next to Johnny Depp’s island.  These are all really simple strategies that anyone can do, and each of which takes less than a couple hours to set up, and can lead to hundreds of thousands of dollars over your investing lifetime.  The Fox family has benefited by these little strategies probably to the tune of 4-5% extra return each year over what seems typical among your average American investor, and that has equated to hundreds of thousands of dollars.

So here’s the bottom line:  As you read this blog, we’ll constantly be finding “extra 1% coupons” that you can redeem to increase your overall investment returns.  As Mrs Grizzly showed, even one of those can add $150k to your nest egg.  If you can gather two or three or even more, you can double your nest egg.

The tax man cometh

2015-02-13 image (grim reaper)

“In this world nothing can be said to be certain, except death and taxes” –Benjamin Franklin

I love this woodcut from the 1600s.  I imagine the artist drew it so the skeleton’s hand is asking for the guy’s life, but it kind of looks like he has his hand out asking for money like he’s collecting taxes.  Either way, if you’re death or the tax man, you probably aren’t too popular.

Obviously taxes are important when you’re thinking about investments and your retirement.  Uncle Sam (for all you foreign readers, what is the name of the personified tax collector in your country?) is definitely going to take his share of your earnings and investments.  Given the progressive nature of most countries’ tax codes, as your nest-egg gets larger and larger, they take a bigger percentage, so that raises the stakes.

The government has built the tax code to offer huge tax breaks to people saving for retirement, particularly allowing people to defer taxes from their earning years to their retirement years. That’s really all that accounts like 401k’s and IRAs are doing, taking money you earn when your income is high and allowing you to pay taxes on it when your income is low.  It may not seem like a big deal at first but suffice it to say, optimally managing your tax situation can be the difference of hundreds of thousands of dollars.  As always, it’s important to remember that I’m not a tax expert; also I’ll be making assumptions on future stock returns which in no way guarantee that is what will actually happen in real life.

 

Working tax rate versus retirement tax rate

US tax rates go up pretty quickly the more money you make.  So when you’re in your prime earning years, that is when your tax rate is going to be the highest.  Take my neighbors Mr and Mrs Grizzly as an example.  They both work and have a combined income of $150,000.  Throw in a couple assumptions like they have two cubs, a mortgage, and live in the great state of California, and they are paying a total of about $41,000 in taxes, about 27% (there’s a great website that I used for these estimates).  Look a little deeper and their marginal tax rate is 43%; that means if they earned one more dollar they would pay $0.43 in taxes, and conversely if they lowered their income by one dollar they would save $0.43 in taxes.  Wow!!!  That’s a lot in taxes.

Now let’s fast forward and think of Mr and Mrs Grizzly in retirement.  Their house is paid off and they don’t have to save for their cubs’ educations, so what they need to support their retirement lifestyle is $80,000 (believe me, I will have many future posts dedicated to estimating how much someone needs per year in retirement, but for now let’s just take the $80k on faith).  Each year they tap into their savings and the $80,000 breaks down into three buckets: $20,000 is interest and dividends; $30,000 is long-term capital gains on the profits from their investments over the years; and $30,000 is the basis, the original money they invested which doesn’t get taxed.  Run your tax calculator again and they’re paying a measly $1,200 in taxes!!!  Read that again; it’s not a misprint.  That’s only 2% compared to the 27% they were paying while they were working.  And their marginal tax rate is 4% in retirement instead of 43% while they were working.

That, my friends, is some powerful stuff!!!  Now, how do Mr and Mrs Grizzly translate that into cash money?

 

The value of deferring taxes

During their working years, Mr and Mrs Grizzly set up their budget to save $1000 per month.  Because they are avid readers of the Stocky Fox, they know they should save that through their 401k’s (in this unfortunate example, let’s assume their cheapskate company doesn’t offer any matching).  In a year they will have saved $12,000 but since 401k’s are tax deferred they don’t pay taxes on that money, saving themselves $5160 in taxes (remember, their marginal tax rate is 43%).  Nearly $5200!!!  That’s some serious honey comb.  They do that each year and after 30 years (let’s assume a 2% dividend and a 5% stock increase), and they have a nice little honey pot of $1.12 million for retirement.  They’ll withdraw their $80,000 per year and pay the lower tax rate on it, and life is good.

The Grizzleys are sitting pretty, but what would happen if didn’t use their 401k to defer taxes and instead invested their money in a normal brokerage account?  Each year, they’d pay the $5200 in taxes but then they would also have to pay taxes on the dividends of their investments at about a 33% marginal tax rate (special thanks to my ChicagoBooth classmate, Rich, for correcting me on this).  If you assume the same investments as we did above, 2% dividends and 5% stock increase, after 30 years they would have $815k.  That’s nothing to sneeze at, but that’s about $300k less than what they had with their 401k.  Those numbers seem crazy, but that’s the power of tax deferral.

2015-02-16 deferred taxes graphic (qd)

So the lesson is that using tax deferred accounts offers a really powerful way to accelerate the growth of your nest-egg by cutting out the tax man (in a totally legal way, of course).

How to get started saving for retirement

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So many people I talk to love the idea of investing for retirement and know they need to be doing it, but they just don’t know how to start the journey.  As a result, they don’t do anything, months and then years go by and they’re still at square one, but now they’re pissed because they missed out on the red-hot stock market that increased 50% over the past few years.  So here is what I would do in order of “Stockiness” (stockiness is a word I just made up that loosely translates to investing wisely).

 

401k or 403b

If you work for a company that offers a 401k or a 403b, that is probably the best and easiest place to start investing.  First, most companies have it set up so it’s pretty easy to sign up and get started.  Also, since they deduct the money out of your paycheck, it might be easier for some people to save the money “without having to do anything”.  Plus there’s the benefit that most of these plans don’t have any minimum amounts you have to start an account with, so you can sign up, have then deduct your 4% or 10% or whatever, and you’re set.

Of course we’ve saved the best for last—there are two MAJOR advantages of 401k and 403b accounts that really help you boost your nestegg.  First, both are tax-deferred (much more on this in a later post) which means that you don’t get taxed on your contributions.  So when you put $10,000 into your 401k this year, you don’t pay taxes on that money; had you not used your 401k then you would be taxed at normal income rates which could go all the way up to 40% or even higher, depending on what your situation is—that’s $4000 right there.  Certainly, you’ll have to pay taxes when you withdraw the money in retirement but it’s pretty likely you’ll be paying a much lower tax rate then, compared to the tax rate you’re paying while you’re working.

The other MAJOR advantage of these accounts is that most companies offer some type of matching.  It’s typically something like they will match $0.50 for every dollar you put into your 401k up to 6% of your salary.  Every company is different on their match but there is one thing they all have in common—they’re giving you free money if you’re willing to take it.  Like so many things in investing, over time this matching can add up to a lot— tens or even hundreds of thousands of dollars for this little jewel.

As with all things, if it seems too good to be true, you should probably read the fine print.  There are a lot of rules associated with 401k and 403b accounts (as I said in the disclaimer, I’m not an expert here).  The big one is when you can withdraw the money.  The government allows those great tax advantages at the cost of limiting your ability to get at the money; the idea is to have you save that money for your retirement, not your next car or next Berkin handbag (which can cost as much as a car—totally blew me away when Foxy Lady told me that).  If you’re in a pinch you can get the money sooner, but it is a major pain in the butt, and often times there are penalties.  So the general rule is: put money in your 401k or 403b that you won’t need until your late 50s.

 

Individual Retirement Accounts (IRAs)

If your job doesn’t offer a 401k or 403b, the next best thing is probably an IRA.  They are similar to 401k accounts in that they have tax advantages that can really add up over time, so that is one of the MAJOR advantages.  Unfortunately, they don’t have the matching feature which is a bummer.  Also, similar to 401k and 403b accounts, these are meant for retirement savings (and have similar penalties for early withdrawal) so it’s best to put money here that you don’t plan on needing until your 50s or 60s.

Unlike 401k and 403b accounts, you have to set these up on your own.  It’s not difficult, but it certainly isn’t as easy as if you just check a box at work.  The first thing you’ll need to do is pick between a Roth IRA or a traditional IRA.  There’s a ton of debate on which is better, but as a general rule I would go with a traditional IRA.  Ironically, when I made that decision for myself 15 years ago I went with a Roth IRA and I think I made the wrong decision.

Then you’ll need to set up an account with Vanguard or Fidelity or one of a hundred other firms.  Another unfortunate feature of IRAs compared to 401k accounts is that they tend to have a minimum amount required to open an account.  For Vanguard it tends to be about $3000, so that may take a little while to gather before you can get started, but it’s still definitely worth the effort.

But there is a nice advantage that IRAs have over 401k accounts—you have many more investment options.  With a 401k you are limited to the mutual funds that the company has set up.  My experience with 401k accounts is that you have a good variety—bond funds, domestic stock funds, international stock funds, target retirement funds—but you may only have 10 or so choices.  With an IRA you can choose from almost any mutual fund there is (just to put that in perspective, Vanguard has 100 funds to choose from).

 

Brokerage account

If neither of the above options work for you (and that would seem really odd that they wouldn’t, but I guess you have your reasons), then you can open a regular brokerage account with Vanguard or Fidelity or others.  Here you could invest in all the same mutual funds that are available to you with IRA accounts.

As you’d expect, the major drawback on these is that they don’t have the tax advantages of the 401k, 403b, or IRA accounts and that can be a pretty huge deal.  On the other hand, they do not have any of the penalties associated with early withdraws, so that might be something attractive depending on what you have on the time horizon.

 

So there you go.  Investing is a long journey, but as some poet who’s been deal a long time said, “Every journey begins with a first step.”  So the first step is opening an account so you can start investing.

 

How did you get started investing?  We’d love to hear your story.