traditional IRA contributions, and about the income limits that apply to them.
First, it’s important to understand that, unlike Roth IRAs, the IRS income limits for traditional IRAs apply only to the tax deductibility of traditional IRA contributions.
But you can still make contributions even if you exceed the income limits.
That is the answer to Anup’s main question.
For 2020, you can contribute up to $6,000 per year, or up to $7,000 per year if you are age 50 or older. What’s more, if your spouse is not employed outside the home and does not have a retirement plan, you can also set up a spousal IRA. That will enable you to make matching contributions to a traditional IRA for him or her, even though he/she has no income.
But let’s get back to those income limits…
The 2020 income limits for tax deductible contributions to a traditional IRA if you ARE covered by an employer retirement plan are:
Married filing jointly – fully deductible up to $104,000; phased out between $104,000 and $124,000; not permitted at $124,000 and above
Single or head of household – fully deductible up to $65,000; phased out between $65,000 and $75,000; not permitted at $75,000 and above
Married filing separately – deduction phased out between 0 and $10,000; not permitted at $10,000 and above
If you are not covered by an employer retirement plan, but your spouse is, you can take a deduction for a traditional IRA up to the following income limits:
Married filing jointly – fully deductible up to $196,000; phased out between $196,000 and $206,000; not permitted at $206,000 and above
Married filing separately – deduction phased out between 0 and $10,000; not permitted at $10,000 and above
Once again, you can still make a contribution to a traditional IRA even if you exceed these income levels.
The contribution however will not be tax deductible. But that doesn’t mean you shouldn’t make a contribution anyway.
In fact, it’s an excellent strategy for a number of reasons…
Retirement Investment Diversification
Having an IRA, in addition to an employer-sponsored plan, is an excellent way to diversify your retirement investments. At a minimum, it will enable you to have more than one retirement plan, which should increase the types of investments that you have.
This is especially important since many employer plans limit your investment options. For example, they may give you a choice between a handful of mutual funds as well as company stock.
But with a self-directed IRA, you can literally have unlimited investment options. The IRA will give you the ability to invest in assets that you cannot hold in your employer plan.
Tax Diversification in Retirement
A nondeductible IRA can provide you with a certain amount of tax-free income in retirement. The investment income that you earn in plan will be tax-deferred, and will therefore be taxable when you begin taking distributions. But since your contributions were not tax-deductible, they will represent tax-free distributions in retirement.
For example, let’s say that you contribute $6,000 to a nondeductible IRA each year for 10 years. At the end of that time, the account is worth $100,000, comprised of $60,000 in contributions, and $40,000 in investment income.
If you were to withdraw $10,000 per year in retirement, $4,000 would be taxable income, but $6,000 – which represents your pro rata nondeductible contributions – will be tax-free.
That strategy will provide you with at least some income in retirement that will not be taxable. That’s tax diversification in retirement.
Making Your Retirement Portfolio Even Bigger
You can save up to $19,500 per year in a 401(k) plan for 2020. But if you also save an additional $6,000 in an IRA, you’ll have $25,500 going toward retirement each year. If you are in a position that you can afford to make such contributions, it can really supercharge your retirement planning. It might even open up the prospect of early retirement.
Looking at it from another direction, the strategy also offers the opportunity to increase retirement savings if you are over 50 and don’t have much saved. That’s because both 401(k)s and IRAs have a “catch-up” provision. At 50 or older, 401(k) contributions can be as high as $26,000 per year. IRA contributions can be as high as $7,000.
If Anup is 50 or older, he can save up to $33,000 per year – $26,000 + $7,000 – toward his retirement. That kind of savings can build up a retirement plan in no time at all.
Setting the Stage for a Lower Tax Roth IRA Conversion
This is another underappreciated reason for doing nondeductible contributions to a traditional IRA. Roth IRAs provide an opportunity to have tax-free income in retirement. They are funded with nondeductible contributions, and the earnings accumulate on a tax-deferred basis. But when you turn 59 1/2, and if you have had your Roth IRA for at least five years, you can take distributions of both your contributions and investment earnings completely tax-free.
The tax-free benefit is the reason why so many people do Roth IRA conversions. That’s the process of converting other retirement plans – 401(k)s, 403(b)s, 457s and traditional IRAs – into Roth IRAs. In doing so, you convert other retirement savings that would produce taxable distributions in retirement, to the Roth IRA, which will provide tax-free distributions.
The downside is when you do a Roth conversion, you have to pay income tax on the amount of retirement savings that has been converted.
But the exception is if you have made after-tax contributions, such as those made to a nondeductible traditional IRA. Since no tax deduction was taken on the contributions, there will be no income tax due on that portion of the conversion.
Let’s take another look at earlier example, of a $100,000 traditional IRA that is comprised of $55,000 in nondeductible contributions, and $45,000 in accumulated investment income.
If you were to do a Roth conversion on that account, only the $45,000 that makes up the accumulated investment portion will be subject to income tax. There’ll be no tax consequences on the $55,000 in nondeductible contributions.
If you were in the 25% federal tax bracket, and you converted $100,000 in retirement assets to a Roth IRA, you’d have to pay $25,000 in federal income tax. But if that plan includes nondeductible contributions of $55,000, the tax bite would be only $11,250 ($45,000 X 25%).
Just as important, if the full $100,000 was taxable, it would probably also push you into a higher tax bracket, resulting in an even larger tax liability. That will be less likely to happen with a traditional IRA which includes nondeductible contributions.
So in a real way, setting up a traditional IRA with nondeductible contributions really sets the stage for a lower tax Roth IRA conversion.
But Hold On – You May Be Able to Do Direct Roth IRA Contributions!
This strategy wasn’t part of Anup’s question, but it may be important for Anup or for other readers who are in this situation. That is, even if you exceed the income limits for deductible traditional IRA contributions, you may still be able to make Roth IRA contributions.
Why?
There is a “window” in the income limits between deductible traditional IRA contributions and Roth IRA contributions.
Consider the following…
The Roth IRA income limits for 2020 are:
Married filing jointly – fully allowed up to $196,000; phase out between $196,000 and $206,000; not permitted at $206,000 and above.
Single, head of household or married filing separately but you DON’T live with your spouse – fully allowed up to $124,000; phased out between $124,000 and $139,000; not permitted at $139,000 and above.
Married filing separately, but you DO live with your spouse – phased out from $0 to $10,000; not permitted at $10,000 and above.
Notice if you’re married filing jointly, you can make a Roth IRA contribution up to an income of between $196,000 and $206,000. But you can make a deductible traditional IRA contribution at an income level of only between $104,000 and $124,000, if you’re married filing jointly, and you’re covered by an employer retirement plan.
Do you see where I’m going with this? If your income is higher than $124,000 – and you can no longer make a tax-deductible traditional IRA contribution – you can still make a Roth IRA contribution if your income does not exceed $196,000.
So let’s say Anup is earning $160,000. Since he is covered by a 401(k) plan at work, he can still make a contribution to a traditional IRA, but it won’t be tax-deductible.
He may decide instead to make a Roth IRA contribution.
Why should he do that? Well, for starters, at that income level, neither a contribution to a traditional IRA nor a Roth IRA will be tax-deductible. And both will allow tax-deferred investment income accumulation. But the difference is that with the Roth IRA, Anup will be entitled to tax-free withdrawals in retirement.
Anup, if you are in that income limit “middle ground” between a tax-deductible traditional IRA contribution and a Roth IRA contribution, you should make a contribution to the Roth IRA instead.
That will also prevent the need to do a costly Roth IRA conversion later.
Thank you Anup, this was an excellent question! It gives us a chance to take a look at something that seems simple on the surface, but has a lot of potential for better options when you consider it from all angles!
There are many places to start contributing to an IRA. If you’re looking for a Roth IRA, specifically, here are the best Roth IRA options today.
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Good Financial Cents, and author of the personal finance book Soldier of Finance. Jeff is an Iraqi combat veteran and served 9 years in the Army National Guard. His work is regularly featured in Forbes, Business Insider, Inc.com and Entrepreneur.
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If you are ready to move your trading up a gear then you need to invest in a scanner or screener. Find out why here.
By
Jeff Broth, Contributor
January 25, 2021
NASDAQ and NYSE have upwards of 7,000 stocks listed, you may wonder how anyone can efficiently identify good targets.
Don’t worry if you aren’t a committed full-time day trader; these apps work just as well for the part-time investor who is looking to put away a few hundred dollars into good quality companies.
The good news is that by using a scanner or screener app, you can quickly find stocks that fall into your investing plan and snap up those bargains early.
Don’t worry if you aren’t a committed full-time day trader; these apps work just as well for the part-time investor who is looking to put away a few hundred dollars into good quality companies.
Scanner and screeners—what’s the difference?
Sometimes people will blur the lines between scanners and screeners. It is important to understand the difference because each are useful for different situations.
A stock screener is a filtering mechanism that will look at a market and filter out stocks that don’t fit your particular strategy.
For example, perhaps you only want NYSE traded stocks, in utility companies, with high trading volumes that have shown a 5% increase over the last week.
A good stock screener will give you a list of the companies that fit your criteria in seconds, providing you with targets to investigate further.
For most modern screener apps, the list of criteria you can choose is almost endless. This gives you the power to spot the type of company stocks you want to buy with pinpoint accuracy.
Stock screeners are one of the first types of apps for investors devised for the internet age. They are designed for people who might log on once a day, download a series of longer-term targets, and then do their research.
In general terms, stock screeners tend to be quite light on resources, which means that you can use them on pretty much any computer or device.
Screeners are great for investors as they give you targets to look for based on a series of attributes. However, they tend not to be used as much by day traders — for that, you need a good stock scanner.
Stock scanners may look similar to screeners but they are quite different. These apps are more useful for active day traders.
Stock scanners bring in real-time information showing stock movements based on a series of criteria that you set.
Because they are real-time, they tend to be used much more by very active day traders who need instant access to quality information.
Many traders look more at current movements in stocks rather than historical results and so they need to spot shares that suddenly have a large volume of trades or swing wildly in terms of price.
Day traders make money from volatility—this means that they need to be constantly looking for stocks that fit into their definition of a target.
Day traders make money from volatility—this means that they need to be constantly looking for stocks that fit into their definition of a target.
Because they take in huge volumes of data and process patterns, movements and fundamentals of stocks instantly, scanner programs require a large amount of computing resources. This means traders need a very capable PC or MAC.
Web-based scanners are available but can tend to be slower. When the difference between a good and bad trade is measured in milliseconds, day traders can’t afford to take a chance.
Scanners and screeners—just the starting point
It’s important to note that scanners and screeners are really only the starting point for a professional investing or trading strategy.
Screeners in particular will only identify potential targets for you to invest in based on the criteria you set. If you set the wrong criteria then you’ll get a list of poor targets—Garbage in Garbage Out (GIGO)!
Professional traders will take the results that they get from a scanner and use that as a jumping-off point to understand whether it is worth investing or not.
Depending upon the type of trader they are, they will look at the fundamentals of a company, including things like a ratio analysis and news research, or perhaps will chart the stock movement over a period of time and then make their move.
It is important to remember that an app really should be seen as one weapon in the armoury for professional traders and only by building up a rounded picture of a stock can you make successful trades.
Things to look for
If you are thinking about using a scanner or screener, then what should you look out for?
Here’s a selection of attributes that are important when looking at this type of tech.
Price—This goes without saying. If you only trade a low volume of stocks then a high priced scanner could wipe out your profit almost instantly!
Usability—This is really important if you are a full-time day trader. Burn out is a real thing and having an app that is easy to use can make life so much easier.
Speedy links—When time is paramount, there’s no place for lags in the connection to the markets.
Markets you like—Your app needs to be connected to the market you are interested in. Not all are.
Understandable—Some older apps require an almost developer-level understanding to produce effective criteria. Make sure you take a trial before signing up.
Multiple elements—Choose an app that can give you access to technical, fundamental, intraday and post-market information for your trades.
The best advice here is to make sure you take a trial (most apps offer free or low-priced trial periods) and really test all aspects of the software to make sure it does what you want, how you want it to.
Scanners and screeners can really make a difference
If you have been running your investment or day trading strategy manually until now then maybe it is time to take the leap.
Using tech to take the strain off of you will give you better access to more suitable targets faster than your peers, which will really ramp up your trading.
Today we’re going to take a look at the well-known Trinity Study. For those who aren’t familiar, don’t worry. I’m going to start off by explaining what the Trinity Study is, how it was done, and how to use its results. It’s all about saving for retirement and planning for retirement.
Table of Contents show
But then I’m going to take a look at a few possible visions of the future. We’re going to create an updated Trinity Study that we can use as part of our retirement planning.
I’m also going to introduce an interesting risk-mitigation tactic. It’s called consumption smoothing. Bears do it, trees do it, and it feels like it should work for retirees. But we’ll see why Mother Nature’s tactics fail in retirement planning.
The What: Describing the Original Trinity Study
If you’re already intimately familiar with the Trinity Study, feel free to skip down to the Wade Pfau section. Right now, we’ll introduce the original Trinity Study.
The Trinity Study was a retirement planning study published in February 1998 issue of AAII by three professors at Trinity College, in Texas. They based their work off of William Bengen’s SAFEMAX study (1994).
The goal of the study was to determine a safe withdrawal rate (SWR) for retirement accounts. A withdrawal rate is the “salary” that you pay yourself during retirement, by withdrawing money from your retirement nest egg—investment options like mutual funds, taxable accounts, tax deferred 401k, tax advantaged Roth IRA, annuities, defined benefit pensions etc. (Social security funds are not part of the Trinity Study).
A safe withdrawal rate is a withdrawal rate that allows a retiree to not run out of money by the time they die. SWR can also be thought of as a portfolio success rate. What’s a sustainable withdrawal rate and asset allocation that leads to retirement success?
Running out of money would be bad—not safe for one’s retirement plans. The Trinity Study aimed to provide a reliable SWR such that retirees would know how at-risk they were to run out of funds.
People in the FIRE movement frequently reference the Trinity Study when planning early retirement withdrawals. If you Google “4% Rule” or “retire with 25x your annual spending,” you’ll see what I mean.
Many FIREees directly tie their Savings Rates to the Trinity Study so they can figure out when it’s safe for them to retire.
Study Assumptions, Method, and Outcome
Let’s dig into the specifics of the Trinity Study. It’s got more nuance than most people in the FIRE community are aware of.
Asset Allocations
The study assumed that most retirees portfolios can be categorized based on their stock and bond allocations. The study looked at portfolio that were 100% stocks + 0% bonds, 75% stocks + 25% bonds, 50/50, 25/75, and 0/100.
This is fair. Most retirees’ portfolios contain a mix of stocks and bonds.
Both in the Trinity Study and Bengen’s original research incorporated long-term, high-grade corporate bonds. Corporate bond returns are typically higher but riskier than government bonds (note: as of January 2021, 10-year treasury bonds are yielding less than 1%. In 1995, they were yielding 7.9%).
The stocks in the portfolios were assumed to be a diverse mix of stocks from developed market countries i.e. a portfolio with returns using historical data. For example, a Vanguard or Fidelity total market index fund.
Summary: the Trinity study examined many mixes of stocks and bonds.
Retirement duration
The study also looked at various lengths of retirement. Some people will retire at 50 and live until 90—a 40-year retirement. Other people retire at 65 and live until 80—a 15-year retirement.
A short retirement might succeed even if the retiree withdraws a high percentage of their nest egg every year. A long retirement, on the other hand, might fail even if the retiree withdraws a lower percentage of their nest egg every year.
Different Withdrawal Rates
The study authors varied their withdrawal rate variable from 3% to 10%.
A 3% withdrawal rate is likely to be more successful—you’re spending less money every year, and allowing more of your money to remain in your portfolio to (ideally) grow. But a low withdrawal rate also leads to a more restricted retirement lifestyle.
A 10% withdrawal rate is opulent, but is more likely to fail. An unfortunate side effect of spending more money is that you’ll quickly run out.
The question, then, is “How do we find the highest withdrawal rate possible while not running out of money?”
Heart of the Trinity Study
The real heart of the study—the question being asked and answered—is:
“If a person retired in Year A, stayed retired for B years, and withdrew C% of their portfolio each year, will they run out of money using a D ratio portfolio of stocks and bonds?
The researchers asked this important question for every single combination of
Year A (from 1926 through 1995)
B years of retirement (from 15 to 40, by multiples of 5)
C% of annual withdrawal (from 3% up go 10%)
and D ratio of stocks and bonds
Ostensibly, a retirement that is too long, or suffers through a bad market, or that withdraws too much money each year…that retirement could run out of money. That retirement could fail.
The withdrawal rates are tested using historical data from 1926 to 1995. For example, when B = 30 years, the authors tested all 30-year rolling periods from 1926 to 1995.
The creation of the 4% Rule
While there are many interesting outcomes from the Trinity Study, the main result has been nicknamed the “4% Rule.” The highlights are the 4% Rule are:
If you use a 4% as Year 1 initial withdrawal, and then slowly increase each year to adjust for inflation… (Study input C)
In a 50/50 stock/bond portfolio… (Input D)
For a 30-year retirement… (Input B)
Then you would have been “safe” for 95% of starting years in the study (Input A)
So this would suggest that a retiree with $1 million dollars could reasonably expect to withdraw $40,000 (which is 4% of $1 million) in their first year and afterwards increase for inflation each year**.
This would have allowed that retiree to successfully live a 30-year retirement without running out of money in 95% of the rolling 30-year periods that the study looked at.
**Note: increasing for inflation is the most-often overlooked aspect of the 4% Rule.
“4%” applies to Year 1 of your retirement. Each subsequent year’s withdrawal assumes you’ve adjusted that number up by the rate of inflation.
The Wade Pfau Updated Trinity Study
Wade Pfau is a professor and PhD in Financial Planning. He’s written excellent pieces on the Trinity Study, including an updated Trinity Study using data through the year 2014.
Along with the extended data set, Pfau also changed the type of bond that the study assumed. The original study used corporate bonds, but Pfau thought it was wiser to look at intermediate-term government bonds.
With this change, Pfau’s outcomes actually look more optimistic than the original study. Pfau found a 100% chance of success (instead of 95%) using the same assumptions that created the original 4% Rule. In Pfau’s update, every 30-year retiree still had money using a 50/50 stock/bond portfolio and withdrawing 4% (plus annual inflation) of their retirement savings each year. This is good news!
But Pfau also asks and examines a crucial question in his updated Trinity Study: will the future look like the past?
Will the future look like the past?
To call this a “million dollar question” would be an understatement. It’s a trillion dollar question.
The Trinity Studies are based on historical market data. That data was taken from a period of wild growth. In the past 100 years, our society has taken unprecedented leaps in manufacturing, technology, and information. Is it wise to assume that the future will look like that past? Will growth continue to be as positive? Should we continute to invest at all-time highs?
The contrarian might point out that the Trinity time periods also included the Great Depression, Stagflation in the 70’s, the Dot Com bubble and the 2008 subprime crisis. So, there are some bad times in there too.
Does it make sense to analyze a scenario where everything is wonderful?
What will our retirements look like if the entire world achieves peace and harmony, enough wealth for daily lattes and avocado toast, and nobody wears clothes?
Is that a question worth answering? And why are all utopias also nudist colonies?
No! That’s not a question worth examining! We don’t need to be worried about utopia.
I say “Hope for the best, but plan for the worst?” That’s what we want to do here. We want to plan on things being tough.
We might have to choose lower withdrawal rates. If we’re right, we’ll be very thankful we planned for it. But if we’re wrong and things are great…well, great! If I’m wrong, I’ll accept “things are great” as a consolation prize.
Just be careful—I don’t want some hairy dude too close to my avocado toast.
The Best Interest Updated Trinity Study Simulation
Riffing off of Wade Pfau, I’m unofficially addending to the Trinity Study to look at possible bleak futures.
Assumptions
To create my version of the updated Trinity Study, I ran Monte Carlo simulations.
I created an alternate reality (no nudists), used randomness to determine the nature and volatility of that reality, and then figured out how a retiree would fare in that reality. Then I repeated that random reality a few million times for different market returns, SWRs, etc.
Some assumptions in my analysis:
I looked at average annual market returns varying from 3% to 7%, calculated on a monthly basis. People often cite the S&P 500 having 9%-10% returns. A balanced, lower-risk portfolio might have 6%-7% returns. But remember, we’re looking at worse markets than the past.
Assumed that monthly portfolio returns have a standard deviation of 3%, due to mix of stocks and bonds. This is based off of historical variations from Burton Malkiel’s data sets.
Used a Laplace distribution to determine the “randomness” in the simulation.
Only looked at 30-year retirements, to keep in line with the oft-quoted result from the original Trinity Study (the 4 percent rule is based on 30-year retirement).
Chose various withdrawal rates using the original study as a guide
Assumed our investor only withdraws their money once per year. E.g. they withdraw $40K on January 1st, and live off that $40K until the following January 1st, etc.
Assumed an annual 3% inflation to calculate the inflation-adjusted withdrawal rate
(For second analysis only) Assumed a 0.5% return on cash (e.g. a high yield savings account).
Keep in mind, this took me a few hours to set up and get results. The actual Trinity authors are career academics and ran their studies like professionals.
I admit than my assumptions and methodology are not as rigorous as theirs. But I think we can glean some insightful information nonetheless.
On Pessimism:
A lot of people felt that my original analysis was too pessimistic. So pessimistic, in fact, that it lost integrity. That it’s worse than the worst-case scenario.
So, I want to emphasize: I’m only asking What if? there’s a terrible, bleak future.
How might someone conservatively alter their retirement goals? How might someone’s current savings plan and savings rate be affected? Is it worth re-checking the retirement calculator?
I, like you, hope the future is as good or better than the past. So I don’t want anyone to start stockpiling precious metals because of my fictional simulation.
In the post-coronavirus investing world of zero percent interest rates, is it so crazy to think that the next few decades might behave differently than the past?
Results
Below is the summary table of results from my random simulations.
The SWR varies by column, and the average annual return varies by row.
The actual entries in the table are the percentage of simulations that created a successful retirement based on a particular combination of SWR and market return.
What sticks out? Where do we start?
To me, I immediately take a look at the 4% SWR column, because that’s what the Trinity Study has convinced us is safe.
If the Market Stagnates Long-term, Then the 4% Rule is in Trouble.
Thankfully, Microsoft Excel has some cool color schemes to help us with the visualization.
If traditional 50/50 portfolios underperform compared to historical precedent, then the 4% rule is in trouble. This isn’t shocking.
If we want to achieve the “security” that the tradition 4% Rule provides, we have to look for a ~95% chance of success. Moving to a 3% or 3.5% Rule immediately provides that safety margin (even in some terrible markets). But, of course, move to a lower withdrawal rate means that we have to save more money in order to maintain the same standard of living.
A few question, though, immediately arise.
First, what are the good reasons to expect this underperformance? Have we ever seen a period perform this poorly?
And second, can we do anything about it?
On the first question: yes, we have seen 50/50 portfolios perform as poorly as 6.17% per year for a full 30-year period.
With government bond rates at historic lows and the stock market at historic highs, there are legitimate concerns over future returns. The optmistic news: average 50/50 portfolio performance is 8.6% per year.
Can we do anything about it?
Consumption Smoothing
One idea that neither the original Trinity Study nor Pfau’s update looked at was the idea of consumption smoothing. In brief, consumption smoothing means “do more when times are good, do less when times are bad.”
To explain more, let’s think about a tree.
Here in chilly Rochester, NY (and other non-equatorial climes) trees only have leaves during the late spring, summer, and early autumn. During the long summer days, the trees absorb as much solar energy as they can.
But during the winter months, days get short. It doesn’t make sense for the tree to maintain its leaves–which consumes resources–for such a short day. Therefore, the tree drops it’s leaves in the autumn and survives off the previous summer’s gathered energy.
Put another way: the tree uses surplus energy gathered during the bountiful summer in order to survive the harsh winter.
For our purposes, consumption smoothing means “withdraw more money when the market is up, and withdraw less when the market is down.”
You know that phrase Buy low, Sell high? Well, consumption smoothing helps you emphasize the Sell high part by withdrawing more money when the market is high. It also prevents you from Selling Low too much, by withdrawing less when the markets are down. You use your extra Sell High money to “smooth out” the bad years that may come later.
Simulation with Consumption Smoothing
So I ran the simulation again, this time using a consumption smoothing algorithm. What did this algorithm look like?
In short, I created a “Cash Reserve” in the simulation, which started at $0. After each year that the market went up, I would pull that both that year’s withdrawal (the SWR amount) and extra money to go into the Cash Reserve. But if the market went down, I used a combination of the previous years’ Cash Reserve and retirement withdrawal to fulfill that year’s spending need.
It’s just like my tree. During good years, we’re the tree in summer. We’re withdrawing money for this year, and money for a time when we’ll need it in the future. During bad years, we’re the tree in winter. We]re borrowing from the good years’ reserve before tapping into our retirement account.
Consumption Smoothing Results
The results might surprise you. It feels like we’re being cautious. We’re “gettin’ while the gettin’ is good.” But what works for bears and trees does not work for retirees.
This is the same exact simulation as before, except with consumption smoothing turned on. Our portfolio failure rate increases dramatically. But why?!
The answer is simple: pulling out extra cash—even during “high” markets—will stifle your long-term portfolio growth. Money left alone in your portfolio will continue to grow. Money that you pull out will cease to grow. Consumption smoothing stifles long-term growth.
Remember John Bogle’s advice:
Don’t do something. Just stand there.
John Bogle
Living beings are trained for action. Trees need to gather sunlight. Humans reward hard work. A bear who doesn’t prepare for winter will surely starve.
But John Bogle succinctly pointed out that markets work in the opposite manner. Interfering with your portfolio doesn’t help. It hurts.
Parting Thoughts about the Updated Trinity Study
At the end of the day, we don’t know what the future will look like. Today, I chose what most people would consider an overly pessimistic view. It can be scary, but as the Roman civium used to say, “praemonitus, praemunitus.” Forewarned is forearmed.
I’m not suggesting that a 2% SWR is needed. I don’t think it’s the only way forward. But I do think it’s worth the mental exercise. How prepared will you be for a pessimistic future?
There are many personal finance ideas that work this way. You can educate yourself on the objective possibilities, but the final decision really comes down to your subjective feelings about risk.
I hope today’s post brought you a new perspective, and provides you with some objective possibilities so that you can make your best financial decisions.
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
Real estate, rental income, stocks … boooooriiiing. These 7 investments can potentially provide an income stream from a very unexpected source!
By
Jim Wang
January 19, 2021
millionaires have 7 streams of income. And most of them are boring. Common examples of income-generating assets include your classics like real estate (rental income, depreciation benefits, equity appreciation) and dividend stocks (dividend income is taxed favorably), which I love.
But every so often, there’s one in there that sounds as exciting as going to Vegas and always betting on black.
Today, I want to talk about those obscure investments. Those weird, you only hear about them in the movies, oddball investments that can produce cash flow. I don’t want the obscure ones that don’t produce cash (invest in whiskey, art, or some other collectible … that just makes you eccentric), these have to produce a stream of income.
Maybe the stock market has you spooked. Maybe you simply have enough in equities.
Maybe you want income but all the income-producing assets you know of are boring (or you have enough) – who really cares about certificates of deposit, Treasury bonds, and dividend stocks. If you wanted them, you would’ve gotten them by now (or you have and want even more diversification).
Today, you’ll read about some truly interesting assets that you’ve probably never heard of before:
I will reference different websites and companies in this list as examples. I haven’t used a single one of them. These are not endorsements.
1. Crowdfunded real estate
Crowdfunded real estate is a relatively new phenomenon. It’s when you can invest in a little piece of real estate as part of a “crowd” of investors. This lets you diversify your real estate holdings without the work of buying and selling properties.
You have some companies, like RealtyMogul, that curate deals and offer you a piece of the investment. There are others, like Fundrise, that run funds that do the investing and you can buy shares of those funds. In both cases, you diversify your risk across several investments and can generate passive cash flow in the process (as well as equity appreciation).
If you aren’t an accredited investor, here is a list of real estate investing sites for non-accredited investors.
2. Peer-to-peer lending
Peer-to-peer lending is older than crowdfunded real estate investing but follows the same principles. You act as a bank, lending money to borrowers, but are able to diversify your loans across a variety of different borrowers with varying levels of risk. By funding loans with $10 and $20, you can deploy thousands of dollars across hundred of borrowers that, hopefully, are not correlated.
3. Mineral rights
Mineral rights are exactly that—the rights to extra minerals from the earth for a specific plot of land. They may be called mineral rights, mineral interests, or mineral estate, but the term is clear. It gives the owner the right to mine and extract minerals from the land.
When you own the mineral rights, you own any valuable minerals trapped in the land.
This is lucrative because when you own the mineral rights, you own any valuable minerals trapped in the land. The most valuable minerals are oil and gas, gold, copper, diamonds, and coal. In the United States, most of the value is in finding oil and gas.
When you own a mineral right, you can reach an agreement with a miner or extractor to receive a royalty based on production. For example, it’s not uncommon for the Lessee (the miner) to pay the Lessor (owner) 1/8th value of what is produced.
If you want to buy mineral rights, do your homework!
4. Structured settlements
Structured settlements are an interesting asset.
Let’s say you slip and fall in a store. You sue the store, because they were negligent, and you reach a settlement with the store. They offer to pay you $5,000 a year for 20 years. You see this a lot whenever there is a settlement on a massive scale with multiple claimants. The responsible party has to do this or they might go bankrupt. If they go bankrupt, no one gets paid.
Structured settlements are fine, except sometimes the person getting the money needs the whole sum. Or they don’t want to wait. That’s when an investor can offer to buy it from them. At this point, it’s really an annuity to the investor.
This area has a bad reputation because sometimes the parties involved don’t behave honorably. They might take advantage of someone in a bad situation and offer a lowball amount for a settlement. Whatever the case may be, the instrument itself is aboveboard.
Continue reading on Wallet Hacks …
About the Author
Jim Wang has been writing about money for over 15 years, most recently at WalletHacks.com. His software engineering background has given him the skills to distill complex financial concepts into easier-to-understand ideas people can use to take control of their lives and build wealth.
Today, we’re going to compare net worth targets by age. How much money should you have as you age? How should your average net worth grow?
Table of Contents show
Digest the 25th, 50th (i.e. average net worth), and 75th percentile data below. In particular, focus on how bleak some of the real savings data looks, and how large swaths of the population fall into these less-than-ideal buckets.
Note: If you have some money but you’re unsure what to do with it, use the financial order of operations.
Apologies to my international readers—most of this data is pulled from or targeted towards U.S. readers. I suggest you use Numbeo to scale these values to your locality.
Let’s get started!
**Note: I recommend using YNAB to track your progress. You and I both get a free month of YNAB if you end up signing yourself (or someone else) up with the link above. No extra cost to anyone involved. You get a 34-day trial, and then an additional free month. That’s two months to figure out if you like it.
The Good Stuff—Average Net Worth By Age
You didn’t come here to scroll to the end of the article to see the average net worth targets. Let’s get to the good stuff!
So here are five expert viewpoints of average net worth targets by age. This initial plot is the 50th percentile, or median, net worth.
Where are these values coming from?
Fidelity
First, I pulled from Fidelity. Their recommendations are all relative to salary (e.g. “3x your salary by age 40”). I used the median American salary by age to convert salary targets into average net worth targets.
Note: Fidelity defines net worth as retirement savings only, and does not count other assets (e.g. your primary home’s value). The other methods below do include other assets beyond your retirement savings.
DQYDJ
Next, I pulled data from DQYDJ. DQYDJ originally pulled of their data from the Federal Reserve Board’s Survey of Consumer Finances (labeled “The Fed” on the plot).
This Fed data is from 2016—the next set of data will come out later this year.
Keep in mind: the stock market is up about 50% since 2016. But for someone who might not have access to the market—or does not have lots of money in the market—that 50% increase might not make a large difference in their average net worth.
This DQYDJ/Fed data is real data. It’s not a hypothetical target or subjective goal. In my charts today, you’ll see three sets of “subjective targets” and only one set of “real data.”
The Balance
Next, the financial aggregation site The Balance follows a similar formula to Fidelity. At particular ages, they say, your average net worth should aim for an ever-growing multiple of your salary.
Financial Samurai
The Financial Samurai, a.k.a. Sam, is a long-time financial blogger with a no-nonsense attitude about saving money. Sam’s lofty targets are for, he says, people who:
Take action rather than complain about an unfair system
Max out their 401kand IRA every year
Save an additional 20% or more after taxes and 401k/IRA contribution
Take calculated risks through investments in various asset classes
Build multiple streams of active and passive income
Work on a side hustle before or after their day job
Focus on the big picture and don’t nitpick with minutiae
Want to achieve financial freedom sooner with their one and only life
Fair enough, Sam! Sam’s high net worth targets are going to be far above average.
The Best Interest
And finally, I took my own stab at some average net worth targets by age. I did this based on deciles of American salaries, typical milestones in the average American’s life (various debts, children, growing salaries) and the savings rates that might rise and fall as a result of those life events.
A young couple might be able to save some money—but having children will put a dent in their savings rates.
As the couple’s salaries rise, savings will increase. But if/when they help their children with college, their savings rates might take another dip.
While young, one’s investments might be higher risk (and higher reward). But as someone ages, their portfolio is likely to trend towards safer investments.
Inflation Multiplier
I also took inflation into account.
The average 30-year old today might be making $40,000 per year. But the average 60-year old today was making $25,000 per year back in 1990 (i.e. when they were age 30). What are the consequences?
While the average 60-year old today might hope to have an average net worth of $800K (Best Interest opinion), that’s not what a current 30-year old should treat as their target or goal.
If we assume 2.5% annual inflation for the next 30 years (leading to a 2.10x total inflation increase), then a 30-year old today should target $800K * 2.10 = $1.68 million by the time they are 60.
Here are some approximate inflation multipliers based on the number of years you want to project into the future. For example, someone age 50 would want to look 20 years into the future if they want to see what their net worth target for age 70 should be.
Number of yearsin future
Inflation multiplier
5
1.13
10
1.28
15
1.45
20
1.64
25
1.85
30
2.10
35
2.37
40
2.69
45
3.04
Looking at the table above, forecasting 20 years in the future requires an inflation multiplier of about 1.64.
Analysis of the Median Net Worth Targets
Let’s take another look at those median net worth targets. What conclusions can we draw?
Of course, this is just my opinion. But the non-Best Interest American net worth target numbers seem low to me.
This is probably an obvious (and biased) conclusion. My method comes up with higher numbers, so I’m going to be biased into thinking the other goals are low. But why do I think so?
Let’s start by analyzing this data through the lens of the “4% Rule,” which states that you should take your annual spending and save ~25x that much for retirement.
The Best Interest target ($850K) allows for a retirement income of roughly $34K ($850K/25) per year, or $2800 per month. Financial Samurai’s targets lead to $40000 per year or $3300 per month. When you add in Social Security benefits, that’s a very reasonable allowance for the average American.
The other methods suggest median net worths of $500K, $300K, and $220K, for a monthly allowance of $1660, $1000, and $730, respectively. With the assistance of Social Security, it’s certainly possible to live off these amounts. But there’s more risk involved.
The average Social Security benefit in 2020 is estimated to be about $1500 per month. Let’s add that to the allowances from the previous paragraph.
Would you feel comfortable living off of $3160, $2500, or $2230 per month? Depending on your area of the country, cost of living, medical expenses, retirement goals, etc., it’s a scary question.
What happens if something goes wrong with your plans? Going back to work at age 80 is not an enticing prospect. Neither is asking your children for a handout.
Are these hyperbolic outcomes? I don’t think so.
How to Compare? Apples to Apples?
Does it make sense to set the same average net worth goals for both a teacher and a doctor? We know that their net worths targets by age will be dramatically different.
The average American doctor’s gross income in 2019 was more than $300K. Meanwhile, the average teacher’s salary was $60K. Of course, there are millions of people that will fall within and without this range. Does it make sense to compare average net worth targets when incomes are so different?
In my opinion, yes it does make sense to do this comparison. But it’s only one data point that you should use—not an end-all-be-all.
It’s just like a young track athlete comparing their race times to record holders. Of course, they’ll be slower than the record holders. But it gives them a target, an understanding of the gap, a percentage difference to track their progress against.
Besides, the comparisons I presented above are median net worth calculations. They account for the highs and the lows, and they let you know where the middle of that scale lands. Some people start from nothing and build net worth. Others benefit from large generational wealth transfer. This average net worth analysis does not discern between the two.
If you’re making a lower salary but you love to be frugal, then set your targets high! Aim for a high net worth that’s a decile or two above your salary decile.
If you’re fresh out of law school, you’ll probably be in a mountain of debt. You might be low on the scale now, but your long-term financial prospects are good.
Keep circumstances like that in mind as you review today’s charts. This is where age, work experience, education level, etc can all play important roles.
Location and Cost of Living
We’ve covered how inflation and income can affect your position in the average net worth plots. But we should also discuss how your cost of living can affect these results.
Life in San Francisco or New York City costs more than life in Rochester, NY. And life in Rochester costs more than life in rural Kansas. Rent, gas, groceries—all these commodities have different prices around the country.
Therefore, the average net worth benchmarks should change with location.
Use the crowd-sourced site Numbeo to do some of these comparisons. For example, here are some results comparing Rochester to Boston—where Numbeo suggests we need 50% more spending in Boston than in Rochester to maintain similar standards of living.
Numbeo uses New York City as a baseline, giving it an indexed score of 100. The United States as a whole has an index score of 56, suggesting that the average American has a cost of living that’s about 44% less than the average NYC resident.
Look up your city or region to compare it to the United States index score of 56. The percentage difference will give you another way to interpret the average net worth results.
For example, Philadelphia has an index of 62, which is 10% higher than 56. If a Philly resident is using today’s data for retirement planning, they should consider adding 10% to all of the data points.
75th Percentile Net Worth Targets by Age
The plot above shows the same five experts’ opinions, but at the 75th percentile.
One interesting aspect of the 75th percentile net worth targets is that the Fidelity recommendation lines up well with the Fed data.
This suggests that people who earn more also save a larger proportion of their income, and people who save more are more likely to meet Fidelity’s thresholds. That’s real data lining up with Fidelity’s subjective targets.
These people have higher average gross income. They have a high net worth. They likely utilize a retirement savings plan. Or they might be the secret millionaire next door.
If we go back to the average net worth chart, we notice that the Fed data lags behind both Fidelity’s targets and the Balance’s targets. In other words: average real-world saving does not meet the average expectations of Fidelity and the Balance.
It takes above-average earning and saving to meet the Fidelity and Balance targets. This is an important point.
It’s not ideal, but it’s reality.
In general, systems that require above-average effort in order to obtain average goals (e.g. to meet suggested average net worth thresholds for retirement) are bad systems.
A good system would only require an average effort to achieve average results. But this is where the Stockdale Paradox is important. Don’t find yourself ten years in the future having not taken action today.
25th Percentile Net Worth Targets by Age
And to make matters worse, check out the 25th percentile chart below.
Here, three of the subjective net worth targets are all in family. Fidelity and my Best Interest targets line up very closely to each other, with the Balance falling 20-30% lower.
But how does the real net worth data compare? At retirement age, real people’s net worths are only 15% to 25% of where they “should” be.
It’d be nice to reach Financial Samurai’s targets, but many people do not have the means to maximize their savings accounts to the extent he recommends.
Let’s put a face to this data. It’s 25th percentile, meaning that one out of four people in the U.S. falls on or below this graph. Dunbar’s Number suggests that the average human can comfortably maintain 150 meaningful relationships–which would suggest that you (yes, you) closely know ~40 people (on average) on or below the 25th percentile plot.
Real people, real lives, real worry. For a 60-year old, to retire on a $50K net worth (or less) is likely impossible to do. On DQYDJ, I looked at the 25th percentile net worth for 70 year olds—it’s $56,000.
25th percentile net worth is meager all the way to the end of life. That’s a sobering fact.
The Wealth Divide
What might be causing this household net worth disparity? How do people have negative net worth, or lower-than-needed net worth?
Rising expenses and wage stagnation is an easy cause to point to. The lack of financial educationhurts. So does poor financial health—like having a low credit score and paying high interest rates. Student loan debt and credit card debt suck.
Some people are behind from the start. Your first net worth out of college is likely to be negative. Many people wake up 10 years later and find their net worth hasn’t grown. That’s the python-squeeze nature of debt.
Wealthier college graduates don’t have to battle that python. It’s not their fault—that’s just how it is. Without that student loan debt, their average net worth increases rapidly.
After 10 years of work, they’re likely to be debt-free. They’re likely to own real estate. They’re more likely to be collecting passive income or contributing to their retirement account. What do all these activities have in common? They all increase net worth!
Sure, annual salary matters. Total household net worth is a function of salary—just ask the Federal Reserve.
But the net worth divide we’ve seen today starts at the beginning of people’s careers and often never closes. It’s there at age 30, age 40, age 50, age 60.
Why Do Net Worth Targets by Age Matter?
I’m just another personal finance writer, but I think average net worth benchmarks are an important metric of financial health.
Your current net worth isn’t make or break, but it let’s you know how you compare to your age group. Age 30 millennials should think about their financial future. Age 60 retirees should be aware of their cash, stocks, bonds, mutual funds, etc.
Personal net worth is like your blood pressure. It’s a good metric of health.
If you’re behind, you need to take action. While something like wealth transfer inheritances usually helps, you probably shouldn’t rely on one. Instead, increase your savings rate. Utilize your 401(k) i.e. pretax income.
Your financial future will grow from your financial present.
What Counts as Net Worth? And What Doesn’t?
Let’s do some housekeeping. What actually counts towards net worth? The answer is subjective, but it comes down to assets minus liabilities.
In general, I considered the following as contributors to net worth (i.e. liquid net worth contributors).
Bank accounts
Retirement accounts (401k, IRAs, etc)
Investments (stocks, bonds, REITs, etc)
Other saving vehicles (e.g. Health Savings Accounts, 529 college savings plans)
Equity in real estate (e.g. your home value)
Common debts—mortgage debt, credit card debt, average student loan debt, etc.
Pension and social security
Note: Fidelity’s targets were based solely on retirement account funds.
And what doesn’t count towards net worth?
The value of common possessions (e.g. a car, a computer)
Illiquid or non-transferrable assets (e.g. airline miles)
And what is a maybe? These are assets that are fairly subjective and up to you.
Collectibles, jewelry, art—how liquid are they? And are you sure you’d want to sell them?
Business ownership—again, how liquid is it? If you can sell shares, that’s good. But if you own a gas station, is that part of your net worth?
Accrued annual vacation days or PTO, unless transferable to cash at future date.
Future inheritance. Probably ok to count if you’re sure you know what you’ll be inheriting.
Life insurance policies. Does it count as net worth if it only comes true after you die?
Today’s values account for a single person. The average American family’s net worth is likely ~double what we’ve presented today. I.e. average household net worth = 2x average individual net worth.
How to Calculate the Value of a Pension or Social Security
This involves a little bit of math. First, I’ll ask you to come up with four important numbers. Then I’ll show you two important equations. And then we’re going to work through an example together.
The four important numbers are:
[N] The number of years you estimate you’ll be retired. If you’re retiring at 60, a safe number to use here would be 25 (assuming you live to the above-average age of 85) [ 85 – 60 = 25 ]
[M] The number of years until you retire. I’m currently 30. If I retire at 60, then the number I’ll use here is 30. [ 60 – 30 = 30 ]
[R] The rate of return of the pension plan or Social Security. Here are some good sources for pension plan historic data and SS historic data. If you want to be safe, use less than 6% for a pension or less than 5% for Social Security.
[P] The assumed annual payment once you retire. For Social Security, here’s a convenient calculator. For pensions, each specific fund will likely have its own rules. Example: a typical pension pay-out might be equal to 50% of a worker’s average salary during their final three years of work.
Equations for Pension/Social Security Value at Retirement and Discounted Current Value
The two important equations are:
Fund Value at Retirement = P * [(1 – (1+R)^(-N)]/R
…we’ll call this Fund Value at Retirement the FV. Next, we need to take the FV and discount it backwards to today’s Present Value, or the PV.
Present Value = FV/[(1+R)^M]
Example: Calculating the Present Value of a Pension Fund
Wallace is a 35-year old teacher. He’ll likely retire at 60. And he’s going to be conservative in estimating that he’ll live to 82.
We now know that N = 82 – 60 = 22 and that M = 60 – 35 = 25.
Being conservative again, Wallace is going to use R = 7% as the fund’s rate of return.
And finally, Wallace knows that his pension will pay him 55% of his final year’s salary. He’s currently making $55,000 and assumes he’ll get a 2% raise for each of the next 25 years. His final year salary, therefore, will be about $90,000. And 55% of $90,000 is $49,500 per year = P.
We now know N, M, R, and P. Let’s plug them into our equations. I like to use Microsoft Excel to help keep track of my values and (if needed) easily change them to adjust my final values.
Future Value = FV = P * [(1 – (1+R)^(-N)]/R = $49500 * [(1 – (1+7%)^(-22)]/7%
FV = $547,531
Present Value = PV = FV/[(1+R)^M] = $547,531/[(1+7%)^25]
PV = $100,882
So, if Wallace wanted to include his pension value in his current net worth calculation, he’d use $100,882.
Retiring for Today
We’re at the 95th percentile for this article. I hope the average net worth comparisons today did not steal your joy, but instead opened your eyes to the wide gradient of net worth targets by age in the U.S.
Net worth targets by age are not an extrinsic competition. They’re intrinsic: will I be able to set up my loved ones and myself for fulfillment today, tomorrow, and for the rest of our lives? At least that’s how I think of it.
Looking at net worth percentile data simply helps gauge whether you’re on track, making progress, or need to change behavior. It’s important to realize—ideally at a younger age—that many people in this country are struggling against themselves in their intrinsic race. I hope today’s post might help you avoid that struggle.
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
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Tagged DQYDY, fidelity, financial samurai, net worth, the balance, the fed
Not sure exactly how big your cash reserve should be or where to keep it? Laura answers listener questions and explains how to build your emergency fund and keep it safe so you’re always prepared for what happens in your financial life.
By
Laura Adams, MBA
January 19, 2021
Investing money means you could get relatively high returns, but that you could also lose some or all of it.
Even though savings accounts currently pay very little interest, that’s the price of keeping money completely safe.
If your emergency money is invested rather than saved, it’s subject to volatility, which means the value could plummet when you need it. Having cash in a bank savings or money market deposit account means that it’s safe no matter what happens in the markets, but you won’t earn much. And that’s okay! Even though savings accounts currently pay very little interest, that’s the price of keeping money completely safe. Again, remember the purpose of those funds isn’t to grow but to be your safety net.
Make sure you always have enough cash on hand to protect yourself from an emergency. I recommend that you maintain a minimum of three to six months’ worth of your living expenses in your bank account at all times.
Tena, I like that you’re also thinking about retirement but make it a separate goal. It’s better to make regular contributions to your 401(k) and max it out when possible than to empty your savings. Tapping a retirement account for a potential emergency isn’t always possible, and if you do take an early withdrawal before age 59.5, you must pay taxes plus a 10% penalty.
I recommend that you maintain a minimum of three to six months’ worth of your living expenses in your bank account at all times.
To calculate the right amount of emergency savings, tally up your living expenses. They are just the basics—like housing, groceries, medicine, transportation, and existing loan payments—not necessarily a full replacement of your income.
For instance, if you could get by on $3,000 per month if you lost all your income, then always keep a minimum of $9,000 ($3,000 x 3 months) in reserve. But having a six-month reserve or more is even better since finding a job could take that long.
When you have extra money or more than a healthy minimum cash reserve, you might consider investing amounts above that threshold. But it’s critical to evaluate the cash reserve you need based on various factors, such as the number of breadwinners in your family, your job stability, marketability, ongoing expenses, and financial goals.
RELATED: 3 Emergency Fund Mistakes to Avoid
Should you invest emergency money?
Vivian W. asks another question about investing emergency money. She says:
I’m 28 years old and currently save about $20,000 per year. I live with my retired mother, who is 66 and didn’t save enough for her retirement. We both have $113,000 in high-yield savings and a CD but want to invest part of it. However, I’m not sure how much cash we should keep in the bank for emergencies. Also, should I be maxing out my Roth IRA every year?
Thanks for your question, Vivian. As I previously mentioned, my recommendation to keep a range of at least three to six months’ worth of your living expenses in savings. You could consider investing the excess. Your cash reserve is like having an insurance policy for you and your mother’s safety.
Vivian, everyone should be investing for their retirement, in addition to maintaining a healthy emergency fund. A good rule of thumb is to invest at least 10% to 15% of your gross income in a workplace retirement account or IRA. The maximum annual IRA contribution for 2020 and 2021 is $6,000, or $7,000 if you’re over age 50. Since you can save $20,000 per year, I would definitely max out your Roth IRA every year.
Should you buy a home with emergency money?
Another common question is whether you should use emergency savings as a down payment on a home. Ann C. says:
I’m 21 years old and will graduate from college in May with a full-time job that starts in 2022 in a large city where I’ve never lived. I have enough savings to make a $20,000 down payment on a home. It seems like spending $1,000 or more per month on rent would be a waste and make it harder to save for a home. Do you think I should own or rent?
Ann, thanks for your question and congratulations on your upcoming graduation, relocation, and new job. That’s a lot to celebrate!
If spending $20,000 on a home would leave you with no cash, you can’t afford to become a homeowner yet. Buying a home is not an emergency. You always need to maintain a healthy cash reserve no matter whether you own or rent.
Buying a home is not an emergency. You always need to maintain a healthy cash reserve no matter whether you own or rent.
Additionally, becoming a homeowner comes with lots of additional expenses on top of your mortgage payment, such as insurance, property taxes, homeowners association fees, furnishings, repairs, and maintenance. Don’t get me wrong—I’m a big proponent of being a homeowner and investing in real estate when you can afford it.
Ann, since you’ve never lived in the city where you’re going for your new job, I’d recommend renting for several reasons. One is that you need time to get to know a new city and see where you want to be relative to your office. Renting gives you time to understand what the traffic is like, whether public transportation is an option for commuting, where you like to spend time when you’re not working, and the state of the real estate market.
I don’t recommend buying a home unless you’re sure you will live in it for at least three to five years. If you start your new job and don’t like it, you might need to sell a home that you just bought to relocate to another part of town or a new city. That may not be a problem, but it’s a bit risky.
I’ve made several cross-country relocations to big cities and have always rented first to get to know the new landscape and my employer. That gives you plenty of time to figure out the parts of town you like and fit your budget.
Renting gives you more mobility and freedom when you’re in an uncertain situation. Also, in many big cities, it’s less expensive to rent than buy a comparable property when considering the total costs of ownership. So, take the time to evaluate your options carefully.
RELATED: 8 Steps to Buying a Home You Can Afford
Should you keep emergency money at home?
You might wonder if keeping some amount of your cash reserve at home is wise. There’s nothing wrong with keeping a small percentage of your emergency money in a safe place at home. It could be helpful in a situation such as a natural disaster when there are widespread power outages.
Typical homeowners or renters insurance doesn’t cover cash.
However, be aware that typical homeowners or renters insurance doesn’t cover cash. So, if your money gets stolen, lost, or destroyed in a fire or storm, you don’t have any recourse.
How to build your emergency fund
If you haven’t started an emergency fund, accumulating several months’ worth of living expenses can seem daunting. Depending on your income and financial situation, it could take years to achieve. That’s okay—just get started by taking small steps every month.
Your emergency savings should be a moving target that you reevaluate every year.
If the pandemic has taught us anything, it’s that we never know what’s around the corner. Your emergency savings should be a moving target that you reevaluate every year.
The first step is to accurately figure your monthly living expenses. As I mentioned, they include housing, utilities, insurance, food, loan payments, transportation, etc. Add up all your current financial needs and obligations for yourself, your family, and third parties that you couldn’t or wouldn’t want to cut if your income was significantly reduced.
The second step is to estimate how long you could potentially need your emergency money. I recommend saving no less than three months’ worth of living expenses. But your unique situation might call for considerably more. Here are some tips to help you determine how much you should set aside:
Consider your income stability. Do you or a spouse work in an industry with volatile consumer demand or one that’s already seen massive declines? If so, this should prompt you to consider saving more than six months of living expenses.
Factor in any potential large expenses. If you might have additional costs to cover, such as a child’s college or a new car, add 10% to your calculated monthly expenses.
Don’t count on selling stuff. When times get tough, it can be challenging to sell possessions quickly to raise cash. So even if you have a valuable collection of jewelry, cars, or artwork, don’t consider it your emergency fund. You need still need cash in the bank to fall back on.
If you’re not a disciplined saver, try automating your emergency savings. Ask your employer to split your paycheck between your regular checking and your emergency savings account. If you get a paper check or are self-employed, set up an automatic monthly or weekly transfer from your checking into your emergency fund.
Ask your employer to split your paycheck between your regular checking and your emergency savings account.
An emergency fund is one of the most critical financial “must-haves.” It should be large enough to get you through a crisis, easily accessible, and in cash to ensure its safety and liquidity, no matter what’s happening in the financial markets.
So, there’s no time to spare in getting started. Once you have a safety net in place, you’ll have a fantastic sense of security and peace that no matter what happens in your financial life, you’re prepared to tackle it.
Personal finances are, well…personal. The advice I give my neighbor is different than what I’d tell you. But there are foundational principles that apply to most everyone. If you want to improve your finances in 2021, I can’t give you specific advice. But I can talk about the foundational principles that help everyone. Let’s discuss those ideas and improve your finances.
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Step 1: Create a Net Worth Statement
You need to know where you stand today. Sum up all your assets and debts. What do you have, where is it, and what job is it doing? This is analogous to stepping on the scale before starting a weight loss plan.
First, what’s in your bank accounts? Checking, savings, etc. And why are you keeping money there? Some of it is likely supporting your monthly expenses. Some of it might act as an emergency fund. But be careful. It is possible to have too much money sitting stagnant in a bank.
Next, how much money do you have in long-term investments? You might own stocks. Maybe you have a 401(k), Roth IRA, or other retirement accounts. If you want to, you can even find the current-day value of your pension or government retirement account.
Many people also include their house and property as an asset. I’ll leave that choice up to you. The argument against doing so is that you can’t live in your house and also sell it for money. You can’t have your cake and eat it too.
After you’ve summed up your assets, you’ve got to account for your debts.
Credit card debt. Student loans. Your mortgage. Car debt. Account for every single debt.
For now, sum your assets and your debts to see where you stand. If you’d like, you can compare compare your net worth to your age group.
But the real point of building a net worth statement will be apparent after today’s exercise is complete.
Step 2: Create SMART Goals
Your net worth statement shows you where you stand. Next, you need to ask where you want to be. It’s time to create SMART goals. The SMART acronym stands for specific, measurable, attainable, relevant, and time-based.
This should be a fun exercise! Write down every goal, big or small. We’ll prune them down later. Use the financial order of operations or your net worth statement to help with ideas.
Note: You can download a free PDF on the financial order of operations. It comes with detailed explanations and a flowchart about optimizing where your dollars go.
Alternatively, I recommend asking yourself some important questions. For example:
Who matters most to you?
What activities do you most enjoy?
How do you prefer to spend your time?
Where do you want to live?
What drives you? What’s your ‘why’?
When do you want to retire?
These kinds of questions will shed light on the best uses of your money, the best ways to improve your finances. That is, how your money can optimize your position on the fulfillment curve.
You can then fit those answers into the SMART framework.
For example, “I want to get out of debt—about $21,400.” We can quickly check off the SMAR boxes, but we can’t do the T (yet).
Or, “I want to pay for my kids’ college. I want to save $250K in the next 15 years.” For this one, I’d argue that the MRT boxes are filled, but we could use some specifics about how attainable it is. How much do you need to save this year in order to reach that goal? Can you actually save that much this year?
Write down some goals for your loved ones, for yourself, for the life you want to live.
And the next steps will help you fill out any missing letters on your SMART goals.
Step 3: Create a Budget
Your budget measures and controls your cashflow. Money coming in (e.g. paychecks) and money going out (all the stuff you buy). Creating and maintaining a budget is the third step to improve your finances.
Your budget informs you how much extra money you’ll have at the end of each month. This is the money that you can use to reach your goals.
In fact, many budgeters—myself included—build their goals directly into their budget. For example: I set aside money every month to eventually purchase a rental property with my brother. It’s part of my budget. It’s part of my process.
In Step 2, we had some partial goals. How long will it take to repay our debt? Our budget tells us. How attainable is paying for our kids’ college? Our budget tells us.
A goal with a budget is a plan. A goal without a budget is just a dream.
This step takes some time, but it’s the habit that will change your future. It’s also the hardest part of this list. Losing 20 pounds is a great goal, but jogging and dieting are tough. Similarly, developing a new budgeting habit can be difficult. The most important part of your budgeting habit is adherence.
If you’re looking for budgeting methods, here are many ways experts budget.
Step 4: Tie It All Together & Improve Your Finances
All the hard work is done. It’s time to tie the steps together.
Your net worth statement (Step 1) showed you where you stand. It highlighted places for improvement.
The goals you created (Step 2) are tied to what’s most important for you. Those goals describe where you want to be, who you want to be with, and what you want to be doing.
Your budgeting (Step 3) informs how much money you can put towards your goals every month. This is how you can ensure your goals are actually SMART.
And now you step back, review your work, and make sure everything is in sync.
Do your goals address holes in your net worth statement? Is your net worth going to improve?
Are your goals specific to what’s most important in your life? Are they SMART?
And does your budget give you the data you need?
This all sounds pretty simple…because it is! If there’s anything I’ve learned in two years of personal finance research and writing, it’s that 90% of money problems are straightforward to fix. Today’s advice isn’t specific to you—but each of the steps asks you to consider your situation. And it will help improve your finances.
I hope you enjoyed today’s Best Interest. Thank you for reading. Consider sharing it with those in your life.
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
It might be a couple weeks before we’re sure who will be in the White House for the next four years. But we’ll have someone. And we’ll have federal, state, and local officials too. I’m convinced that these folks can implement creative personal finance policies that will help you and me. So here are seven ideas for future personal finance policies.
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P.S.—If you know Joe, send him this link.
Basic Tenets and Rules Behind the Ideas
I wanted these personal finance policies to meet three basic criteria.
1) Large Marginal Benefits
$1000 means more to a single, working-class mother than it does to Bill Gates. The marginal benefit for her is greater. Maximizing these marginal benefits is a utilitarian choice.
I’ve written extensively about the role of luck in society. The lucky owe a debt. The unlucky deserve a credit. This first tenet is an extension of those thoughts.
2) Incentivize Positive Behavior
You don’t want to give money for nothing (or chicks for free). Instead, we want our tax dollars to incentivize good behavior. Or even better, we’d like the benefits to scale upwards as the good behavior scales upwards. This is a principle of behavioral economics (e.g. nudge theory).
3) Find a Fiscal Balance
Some believe the government owes you nothing. Others think the government owes you everything. Most of us are somewhere in between. That’s why I aim for a “fiscal balance” in today’s proposals.
And One Tacit Assumption
I’m making an overarching assumption in this post. Namely, the assumption that positive personal finance behavior is a virtue.
I’m assuming that keeping money in people’s hands is not only good for those individual people, but also good for society.
I’m assuming that paying credit card interest and student loan interest is bad for individuals, and therefore bad for society.
Financial stability leads to happiness. It leads to better health outcomes. And when more people are happy and healthy, society improves.
We all do better when we all do better.
There Will Be Shortcomings
I’m jotting these ideas down on election night. I’m doing a little research, but I’m sure I’ll miss something. I’ll mistakenly create a perverse incentive. Maybe I’ll mess up my math and propose a trillion-dollar aid package. Or maybe you’ll just think my ideas are just dumb.
If (when) I mess something up, drop me a message. Real politicians have teams of aides and trusted advisors. I have you—and I’m very thankful for that.
And with that, let’s get started on my list of seven ideas for future personal finance policies.
1) Help with Student Loan Interest
I wrote a detailed, mathematical explanation of this idea. I think we should help students with their student loan interest, which is different than helping them with loan principal. Let me give you the summary.
First off, interest is the killer. It’s “normal” for someone to spend $200K to repay a $100K loan. How? Because of interest.
My proposal is that government funding can help pay the interest, but only if the debtor is willing to contribute a significant amount of their income. The more income the debtor contributes, the more the government contributes.
Let’s apply some hard numbers.
Imagine a former student with $100,000 in total student debt
…at a 5% interest rate
…with the ability to make $750 per month payments
In the current reality, this person must pay principal and interest. They’ll end up paying a total of $144,535 over 16 years.
But If We Encouraged Them to Pay More?
But what if we had an incentive system that encouraged people to contribute more to debt repayment in exchange for government-funded interest-only payments? Hard numbers: what if this person contributed $1000 per month and the government covered 50% of the interest payments?
In this scenario, the debtor pays $111,935 over 12 years. They save $33,000 and get out of debt four years earlier.
But at what cost? The government picks up $11,935 worth of interest payments over those 12 years, or about $106/month on average.
We asked the debtor to increase their monthly payments by 33%. Get out of debt faster—that’s good. We’ve spent $12K in tax dollars to give the individual $33K—some of which will surely end up back in the tax coffers eventually!
Who loses? I’m sure the loan servicing industry will raise some questions. Over the long haul, they are losing out on interest payments—and that’s how they make their money.
Also, there are some ~45 million Americans in student debt, with an average of $30,000 debt per person. That’s ~$1.35 trillion total. If my proposal has the government contributing interest payments equal to ~10% of each person’s loan principal, then we’re looking at a $135 billion bill (spread out over many years). Not exactly couch cushion money.
So maybe it’s smarter to set the bar lower. Perhaps $135 billion is way too high. But the principle stands. By merely helping with student loan interest, we can help a lot of people out.
2) Government-Funded Matching
Many of us get an “employer match” as an employment benefit. If we contribute to our retirement account (e.g. 401(k)), then our employer will also contribute to that account. It’s free money.
What if Uncle Sam did something similar?
Now, it couldn’t be too much free money. And I doubt the money could be doled out at a 1:1 ratio (e.g. you contribute $1000, Uncle Sam contributes $1000). But I do think we could incentivize positive behavior (contributing to a retirement account) via a small financial incentive (government-funded matching).
How about something like a 10% match on the first $5000 contributed each year into a retirement account. If 100 million U.S. workers took full advantage of this program, it would cost $50 billion per year to fund.
But keep in mind! That would also mean that 100 million people are making significant contributions to their retirements. That is very good for the welfare of our citizenry.
Assuming someone takes advantage of this benefit from age 22 to 62, the U.S. government will have provided them with $20,000 in benefits. But assuming historical average S&P 500 returns, this person can expect those benefits to grow to ~$100,000. The first year’s $500 will have grown to $7000 assuming a 7% annual real rate of return.
As for marginal utility, it probably doesn’t make sense to offer this benefit to millionaires. The extra $500 per year doesn’t do them much good. So, like many other government programs, it makes sense to cap this benefit at a certain income and then taper off the benefit.
And where does this money go? I’m sure that there is some issue with the government pouring money into S&P 500 index funds, even if on behalf of individual citizens. The details need to be worked. I still think it’s a cool idea.
3) “Baby Bond” Investments
Or maybe “Baby Stock” investments. When a kid is born, the U.S. government should invest in their name until they are “X” years old. They can’t touch it until then.
First, this employs a similar benefit to government-funded matching idea. Namely, the government puts forth a small investment today and the individual reaps a large benefit in the future.
Secondly, if “X” is high enough, then this investment can teach a very valuable lesson. Investments grow! How better can a young person learn about investing than by watching their investments grow throughout their childhood?
About 4 million kids are born in the U.S. each year. If they each received a $1000 investment, it would cost the U.S. government $4 billion to fund. Not bad compared to my first two ideas.
By the time that child retires (at age 60), that small $1000 investment will have grown to $58000—again, this assumes a 7% real rate of return.
4) Personal Finance Education
The American education system does many things well. Finger painting, carrying the zero, reading Shakespeare. It’s not easy to educate millions of kids and young adults every year, and our schools do alright.
But our education system is woefully insufficient at financial education. I’m not talking about the intricacies of trickle-down economics or how to broker a merger on Wall Street. Forget about index funds and the Trinity Study. I’m simply talking about savings accounts and credit cards, about how to create (and stick to) a budget, or how (and when) to start thinking about retirement. Basic stuff that everyonemust deal with.
I understand that Pythagoras is important. I know that the mitochondria is the powerhouse of the cell. These are good things to be aware of. Just like personal finance.
So why didn’t anyone ever teach me about personal finance?!—a topic I’d have to think about on a weekly (if not daily) basis for the rest of my life.
You’ve probably asked that question. I know I have. And in my pursuit of answers, I started a blog.
But the real point is that all adults realize—eventually—that personal finance education is a requirement for success. Just stick to the simple stuff. It’s hard to function in society without a cursory knowledge of money and credit cards and bank accounts.
Public personal finance education could solve a lot of the money issues we talk about here. That’s money well-spent. It might be the most useful of the personal finance policies I discuss today.
And with the marvel of the Internet, imagine if we created a comprehensive, online personal finance course that anyone could take from the comfort of their own home. Anyone want to start a non-profit with me?!
5) HSA-like Accounts for Personal Finance
A Health Savings Account offers significant tax benefits if you to put money away for medical costs. And if you never use that money for medical needs, you can access it at retirement like a Roth IRA. In the interim—between now and retirement—you can even invest those HSA funds. Utilizing an HSA is an excellent idea if you’re able.
I’d propose a parallel account—the Personal Finance Savings Account. It would offer similar tax-advantages as an HSA. But you would use the PFSA funds to do things like pay for tax preparation or investing fees. You could buy personal finance education material or buy budgeting software. The PFSA would incentivize smart money choices.
And if you never use your PFSA funds? Then you can access them at retirement. That’s smart too.
Imagine if you could set aside $250 per year in tax-free dollars. That might cost the government ~$50 per person in lost tax revenue. There are ~30 million HSAs. If an equivalent number of people take advantage of PFSAs, then the Uncle Sam would lose roughly $1.5 billion in tax revenue per year.
6) Credit Score Bonus
I have two related ideas here. The first is an incentive to have a high credit score. The second is an incentive to increase one’s credit score. These two options are analogous to the growth vs. proficiency debate in education. Either way, the goal is to incentivize improved credit scores.
“But Jesse, there’s already an incentive for having a good credit score! You get to pay lower interest rates!”
That’s true. But “paying lower interest rates” is both too far out in the future and not tangible. What’s the different between a 3.1% mortgage rate and a 3.3% rate? If you have to get out a calculator or spreadsheet to answer, then my point is made. It’s not tangible enough.
But a $100 check in the mail? That’s tangible!
7) Personal Finance Testing
Pass a personal finance test, get paid. I know this is a pipe dream. I’m just spit-balling. But in some sort of anti-cheating utopia, this would be an effective method of encouraging personal finance education.
What Are Your Personal Finance Policies?
What are your ideas?
Where could we allocate money to incentivize the best personal finance behavior?
What dumb things have I written above?
Thanks For Reading
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
One of the most common questions I receive from readers like you—especially since Grow (Acorns + CNBC) published my story last week—asks me how I invest.
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All this theoretical investing information is fine, Jesse. But can you please just tell me what you do with your money.
That’s what I’ll do today. Here’s a complete breakdown of how I invest, how the numbers line up, and why I make the choices I make.
Disclaimer
Of course, please take my advice with a grain of salt. Why?
My strategy is based upon my financial situation. It is not intended to be prescriptive of your financial situation.
I’ve hesitated writing this before because it feels one step removed from “How I Vote” and “How I Pray.” It’s personal. I don’t want to lead you down a path that’s wrong for you. And I don’t want to “show off” my own choices.
I’m an engineer and a writer, not a Wall Street professional. And even if I was a Wall Street pro, I hope my prior articles on stock picking and luck vs. skill in the stock market have convinced you that they aren’t as skilled as you might think.
All I can promise you today is transparency. I’ll be clear with you. I’ll answer any follow-up questions you have. And then you can decide for yourself what to do with that information.
Are we clear? Let’s get to the good stuff.
How I Invest, and In What Accounts…?
In this section, I’ll detail how much I save for investing. Then the next two sections will describe why I use the investing accounts I use (e.g. 401(k), Roth IRA) and which investment choices I make (e.g. stocks, bonds).
How much I save, and in what accounts:
401(k)—The U.S. government has placed a limit of $19,500 on employee-deferred contributions in 2020 (for my age group). I aim to hit the full $19,500 limit.
401(k) matching—My employer will match 100% of my 401(k) contributions until they’ve contributed 6% of my total salary. For the sake of round numbers, that equates to about $6,000.
Roth IRA—The U.S. government has placed a limit of $6,000 on Roth IRA contributions (for my earnings range) in 2020. I am aiming to hit the full $6,000 limit.
Health Savings Account—The U.S. government gives tremendous tax benefits for saving in Health Savings Accounts. And if you don’t use that money for medical reasons, you can use it like an investment account later in life. I aim to hit the full $3,500 limit in 2020.
Taxable brokerage account—After I achieved my emergency fund goal (about 6 months’ of living expenses saved in a high-yield savings account), I started putting some extra money towards my taxable brokerage account. My goal is to set aside about $500 per month in that brokerage account.
That’s $41,000 of investing per year. But a lot of that money is actually “free.” I’ll explain that below.
Why Those Accounts?
The 401(k) Account
First, let’s talk about why and how I invest using a 401(k) account. There are three huge reasons.
First, I pay less tax—and so can you. Based on federal tax brackets and state tax brackets, my marginal tax rate is about 30%. For each additional dollar I earn, about 30 cents go directly to various government bodies. But by contributing to my 401(k), I get to save those dollars before taxes are removed. So I save about 30% of $19,500 = $5,850 off my tax bill.
Editor’s Note: The original version of this article incorrectly stated that 401(k) contributions are taken out prior to OASDI (a.k.a. social security) taxes. That claim was incorrect. 401(k) contributions occur only after OASDI taxes are assessed.
Many thanks to regular reader Nick for catching that error.
Second, the 401(k) contributions are removed before I ever see them. I’m never tempted to spend that money because I never see it in my bank account. This simple psychological trick makes saving easy to adhere to.
Third, I get 401(k) matching. This is free money from my employer. As I mentioned above, this equates to about $6,000 of free money for me.
Roth Individual Retirement Account (IRA)
Why do I also use a Roth IRA?
Unlike a 401(k), a Roth IRA is funded using post-tax dollars. I’ve already paid my 30% plus OASDI taxes, and then I put money into my Roth. But the Roth money grows tax-free.
Let’s fast-forward 30 years to when I want to access those Roth IRA savings and profits. I won’t pay any income tax (~30%) on any dividends. I won’t pay capital gains tax (~15%) if I sell the investments at a profit.
I’m hoping my 30-year investment might grow by 8x (that’s based on historical market returns). That would grow this year’s $6000 contribution up to $48000—or about $42000 in profit. And what’s ~15% of $42000? About $6,300 in future tax savings.
Health Savings Account (H.S.A.)
The H.S.A. account has tax-breaks on the front (36.7%, for me) and on the back (15%, for me). I’m netting about $1300 up-front via an H.S.A, and $4,200 in the future (similar logic to the Roth IRA).
Taxable Brokerage Account
And finally, there’s the brokerage account, or taxable account. This is a “normal” investing account (mine is with Fidelity). There are no tax incentives, no matching funds from my employer. I pay normal taxes up front, and I’ll pay taxes on all the profits way out in the future. But I’d rather have money grow and be taxed than not grow at all.
Summary of How I Invest—Money Invested = Money Saved
In summary, I use 401(k) plus employer matching, Roth IRA, and H.S.A. accounts to save:
About $7,100 in tax dollars today
About $6,000 of free money today
And about $10,500 in future tax dollars, using reasonable investment growth assumptions
Don’t forget, I still get to access the investing principal of $41,000 and whatever returns those investments produce! That’s on top of the roughly $25,000 of savings mentioned above.
I choose to invest a lot today because I know it saves me money both today and tomorrow. That’s a high-level thought-process behind how I invest.
How I Invest: Which Investment Choices Do I Make?
We’ve now discussed 401(k) accounts, Roth IRAs, H.S.A. accounts, and taxable brokerage accounts. These accounts differ in their tax rules and withdrawal rules.
But within any of these accounts, one usually has different choices of investment assets. Typical assets include:
Stocks, like shares of Apple or General Electric.
Bonds, which are where someone else borrows your money and you earn interest on their debt. Common bonds give you access to Federal debt, state or municipality debt, or corporate debt.
Real estate, typically via real estate investment trusts (REITs)
Commodities, like gold, beef, oil or orange juice
Here are the asset choices that I have access to in my various accounts:
401(k)—my employer works with Fidelity to provide me with about 20 different mutual funds and index funds to invest in.
Roth IRA—this account is something that I set up. I can invest in just about anything I want to. Individual stocks, index funds, pork belly futures etc.
H.S.A.—this is through my employer, too. As such, I have limited options. But thankfully I have low-cost index fund options.
Taxable brokerage account—I set this account up. As such, I can invest in just about any asset I want to.
My Choice—Diversity2
How I invest and my personal choices involve two layers of diversification. A diverse investing portfolio aims to decrease risk while maintaining long-term investing profits.
The first level of diversification is that I utilize index funds. Regular readers will be intimately familiar with my feelings for index funds (here 28 unique articles where I’ve mentioned them).
By nature, an index fund reduces the investor’s exposure to “too many eggs in one basket.” For example, my S&P 500 index fund invests in all S&P 500 companies, whether they have been performing well or not. One stellar or terrible company won’t have a drastic impact on my portfolio.
But, investing only in an S&P 500 index fund still carries risk. Namely, it’s the risk that that S&P 500 is full of “large” companies’ stocks—and history has proven that “large” companies tend to rise and fall together. They’re correlated to one another. That’s not diverse!
Lazy Portfolio
To battle this anti-diversity, how I invest is to choose a few different index funds. Specifically, my investments are split between:
Large U.S. stock index fund—about 40% of my portfolio
Mid and small U.S. stock index fund—about 20% of my portfolio
Bond index fund—about 20%
International stocks fund—about 20%
This is my “lazy portfolio.” I spread my money around four different asset class index funds, and let the economy take care of the rest.
Each year will likely see some asset classes doing great. Others doing poorly. Overall, the goal is to create a steady net increase.
An asset class “quilt” chart from 2010-2019, showing how various asset classes perform each year.
Twice a year, I “re-balance” my portfolio. I adjust my assets’ percentages back to 40/20/20/20. This negates the potential for one “egg” in my basket growing too large. Re-balancing also acts as a natural mechanism to “sell high” and “buy low,” since I sell some of my “hottest” asset classes in order to purchase some of the “coldest” asset classes.
Any Other Investments?
In June 2019, I wrote a quick piece with some thoughts on cryptocurrency. As I stated then, I hold about $1000 worth of cryptocurrency, as a holdover from some—ahem—experimentation in 2016. I don’t include this in my long-term investing plans.
I am paying off a mortgage on my house. But I don’t consider my house to be an investment. I didn’t buy it to make money and won’t sell it in order to retire.
On the side, I own about $2000 worth of collectible cards. I am not planning my retirement around this. I do not include it in my portfolio. In my opinion, it’s like owning a classic car, old coins, or stamps. It’s fun. I like it. And if I can sell them in the future for profit, that’s just gravy on top.
Enter full nerd mode!
Summary of How I Invest
Let’s summarize some of the numbers from above.
Each year, I aim to save and invest about $41,000. But of that $41K, about $15K is completely free—that’s due to tax benefits and employer matching. And using reasonable investment growth, I think these investments can save me $15,000 per year in future tax dollars.
Plus, I eventually get access to the $41K itself and any investment profits that accrue.
I take that money and invest in index funds, via the following allocations:
40% into a large-cap U.S. stock index fund
20% into a medium- and small-cap U.S. stock index fund
20% into an international stock index fund
And 20% into a bond index fund
The goal is to achieve long-term growth while spreading my eggs across a few different baskets.
And that’s it! That’s how I invest. If you have any questions, please leave a comment below or drop me an email.
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
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Tagged 401(k), how i invest, hsa, index fund, roth ira
Do you have kids? Are there children in your life? Were you once a child? If you plan on helping pay for a child’s future education, then you’ll benefit from this complete guide to 529 plans. We’ll cover every detail of 529 plans, from the what/when/why basics to the more complex tax implications and investing ideas.
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This article was 100% inspired by my Patrons. BetweenJack, Nathan, Remi, other kiddos in my life (and a few buns in the oven), there are a lot of young Best Interest readers out there. And one day, they’ll probably have some education expenses. That’s why their parents asked me to write about 529 plans this week.
What is a 529 Plan?
The 529 college savings plan is a tax-advantaged investment account meant specifically for education expenses. As of the passage of the Tax Cuts and Jobs Act (in 2017), 529 plans can be used for college costs, K-12 public school costs, or private and/or religious school tuition. If you will ever need to pay for your children’s education, then 529 plans are for you.
529 plans are named in a similar fashion as the famous 401(k). That is, the name comes from the specific U.S. tax code where the plan was written into law. It’s in Section 529 of Internal Revenue Code 26. Wow—that’s boring!
But it turns out that 529 plans are strange amalgam of federal rules and state rules. Let’s start breaking that down.
Tax Advantages
Taxes are important! 529 college savings plans provide tax advantages in a manner similar to Roth accounts (i.e. different than traditional 401(k) accounts). In a 529 plan, you pay all your normal taxes today. Your contributions to the 529 plan, therefore, are made with after-tax dollars.
Any investment you make within your 529 plan is then allowed to grow tax-free. Future withdrawals—used for qualified education expenses—are also tax-free. Pay now, save later.
But wait! Those are just the federal income tax benefits. Many individual states offer state tax benefits to people participating in 529 plans. As of this writing, 34 states and Washington D.C. offer these benefits. Of the 16 states not participating, nine of those don’t have any state income tax. The seven remaining states—California, Delaware, Hawaii, Kentucky, Maine, New Jersey, and North Carolina—all have state income taxes, yet do not offer income tax benefits to their 529 plan participants. Boo!
This makes 529 plans an oddity. There’s a Federal-level tax advantage that applies to everyone. And then there might be a state-level tax advantage depending on which state you use to setup your plan.
Two Types of 529 Plans
The most common 529 plan is the college savings program. The less common 529 is the prepaidtuition program.
The savings program can be thought of as a parallel to common retirement investing accounts. A person can put money into their 529 plan today. They can invest that money in a few different ways (details further in the article). At a later date, they can then use the full value of their account at any eligible institution—in state or out of state. The value of their 529 plan will be dependent on their investing choices and how those investments perform.
The prepaid program is a little different. This plan is only offered by certain states (currently only 10 are accepting new applicants) and even by some individual colleges/universities. The prepaid program permits citizens to buy tuition credits at today’s tuition rates. Those credits can then be used in the future at in-state universities. However, using these credits outside of the state they were bought in can result in not getting full value.
You don’t choose investments in the prepaid program. You just buy credit’s today that can be redeemed in the future.
The savings program is universal, flexible, and grows based on your investments.
The prepaid program is not offered everywhere, works best at in-state universities, and grows based on how quickly tuition is changing (i.e. the difference between today’s tuition rate and the future tuition rate when you use the credit.)
Example: a prepaid credit would have cost ~$13,000 for one year of tuition in 2000. That credit would have been worth ~$24,000 of value if used in 2018. (Source)
What are “Qualified Education Expenses?”
You can only spend your 529 plan dollars on “qualified education expenses.” Turns out, just about anything associated with education costs can be paid for using 529 plan funds. Qualified education expenses include:
Tuition
Fees
Books
Supplies
Room and board (as long as the beneficiary attends school at least half-time). Off-campus housing is even covered, as long as it’s less than on-campus housing.
Student loans and student loan interest were added to this list in 2019, but there’s a lifetime limit of $10,000 per person.
How Do You “Invest” Your 529 Plan Funds?
529 savings plans do more than save. Their real power is as a college investment plan. So, how can you “invest” this tax-advantaged money?
There’s a two-part answer to how your 529 plan funds are invested. The first part is that only savings plans can be invested, not prepaid plans. The second part is that it depends on what state you’re in.
For example, let’s look at my state: New York. It offers both age-based options and individual portfolios.
The age-based option places your 529 plan on one of three tracks: aggressive, moderate, or conservative. As your child ages, the portfolio will automatically re-balance based on the track you’ve chosen.
The aggressive option will hold more stocks for longer into your child’s life—higher risk, higher rewards. The conservative option will skew towards bonds and short-term reserves. In all cases, the goal is to provide some level of growth in early years, and some level of stability in later years.
The individual portfolios are similar to the age-based option, but do not automatically re-balance. There are aggressive and conservative and middle-ground choices. Thankfully, you can move funds from one portfolio to another up to twice per year. This allowed rebalancing is how you can achieve the correct risk posture.
Advantages & Disadvantages of Using a 529 Plan
The advantages of using the 529 as a college investing plan are clear. First, there’s the tax-advantaged nature of it, likely saving you tens of thousands of dollars. Another benefit is the aforementioned ease of investing using a low-maintenance, age-based investing accounts. Most states offer them.
Other advantages include the high maximum contribution limit (ranging by state, from a low of $235K to a high of $529K), the reasonable financial aid treatment, and, of course, the flexibility.
If your child doesn’t end up using their 529 plan, you can transfer it to another relative. If you don’t like your state’s 529 offering, you can open an account in a different state. You can even use your 529 plan to pay for primary education at a private school or a religious school.
But the 529 plan isn’t perfect. There are disadvantages too.
For example, the prepaid 529 plan involves a considerable up-front cost—in the realm of $100,000 over four years. That’s a lot of money. Also, your proactive saving today ends up affecting your child’s financial aid package in the future. It feels a bit like a punishment for being responsible. That ain’t right!
Of course, a 529 plan is not a normal investing account. If you don’t use the money for educational purposes, you will face a penalty. And if you want to hand-pick your 529 investments? Well, you can’t do that. Similar to many 401(k) programs, your state’s 529 program probably only offers a few different fund choices.
529 Plan FAQ
Here are some of the most common questions about 529 education savings plans. And I even provide answers!
How do I open a 529 plan?
Virtually all states now have online portals that allow you to open 529 plans from the comfort of your home. A few online forms and email messages is all it takes.
Can I contribute to someone else’s 529?
You sure can! If you have a niece or nephew or grandchild or simply a friend, you can make a third-party contribution to their 529 plan. You don’t have to be their parent, their relative, or the person who opened the account.
Investing in someone else’s knowledge is a terrific gift.
Does a 529 plan affect financial aid?
Short answer: yes, but it’s better than how many other assets affect financial aid.
Longer answer: yes, having a 529 plan will likely reduce the amount of financial aid a student receives. The first $10,000 in a 529 plan is not part of the Expected Family Contribution (EFC) equation. It’s not “counted against you.” After that $10,000, remaining 529 plan funds are counted in the EFC equation, but cap at 5.46% of the parental assets (many other assets are capped higher, e.g. at 20%).
Similarly, 529 plan distributions are not included in the “base year income” calculations in the FAFSA application. This is another benefit in terms of financial aid.
Finally, 529 plan funds owned by non-parents (e.g. grandparents) are not part of the FAFSA EFC equation. This is great! The downside occurs when the non-parent actually withdraws the funds on behalf of the student. At that time, 50% of those funds count as “student income,” thus lowering the student’s eligibility for aid.
Are there contribution limits?
Kinda sorta. It’s a little complicated.
There is no official annual contribution limit into a 529 plan. But, you should know that 529 contributions are considered “completed gifts” in federal tax law, and that those gifts are capped at $15,000 per year in 2020 and 2021.
After $15,000 of contributions in one year, the remainder must be reported to the IRS against the taxpayer’s (not the student’s) lifetime estate and gift tax exemption.
Additionally, each state has the option of limiting the total 529 plan balances for a particular beneficiary. My state (NY) caps this limit at $520,000. That’s easily high enough to pay for 4 years of college at current prices.
Another state-based limit involves how much income tax savings a contributor can claim per year. In New York, for example, only the first $5,000 (or $10,000 if a married couple) are eligible for income tax savings.
Can I use my state’s 529 plan in another state? Do I need to create 529 plans in multiple states?
Yes, you can use your state’s 529 plan in another state. And mostly likely no, you do not need to create 529 plans in multiple states.
First, I recommend scrolling up to the savings program vs. prepaid program description. Savings programs are universal and transferrable. My 529 savings plan could pay for tuition in any other state, and even some other countries.
But prepaid tuition accounts typically have limitations in how they transfer. Prepaid accounts typically apply in full to in-state, state-sponsored schools. They might not apply in full to out-of-state and/or private schools.
What if my kid is Lebron James and doesn’t go to college? Can I get my money back?
It’s a great question. And the answer is yes, there are multiple ways to recoup your money if the beneficiary doesn’t end up using it for education savings.
First, you can avoid all penalties by changing the beneficiary of the funds. You can switch to another qualifying family member. Instead of paying for Lebron’s college, you can switch those funds to his siblings, to a future grandchild, or even to yourself (if you wanted to go back to school).
What if you just want you money back? The contributions that you initially made come back to you tax-free and penalty-free. After all, you already paid taxes on those. Any earnings you’ve made on those contributions are subject to normal income tax, and then a 10% federal penalty tax.
The 10% penalty is waived in certain situations, such as the beneficiary receiving a tax-free scholarship or attending a U.S. military academy.
And remember those state income tax breaks we discussed earlier? Those tax breaks might get recaptured (oh no!) if you end up taking non-qualified distributions from your 529 plan.
Long story short: try to the keep the funds in a 529 plan, especially is someone in your family might benefit from them someday. Otherwise, you’ll pay some taxes and penalties.
Graduation
It’s time to don my robe and give a speech. Keep on learning, you readers, for:
An investment in knowledge pays the best interest
-Ben Franklin
Oh snap! Yes, that is how the blog got its name. Giving others the gift of education is a wonderful thing, and 529 plans are one way the U.S. government allows you to do so.
If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.
This article—just like every other—is supported by readers like you.
