It’s Friday, and you know what that means: time for another Reader Case!
Today’s contestant is just starting out, but he’s run smack dab into a problem that we all face when attempting to achieve financial independence: the finance industry.
My wife and I discovered your blog and feel that we are in a position to achieve financial independence and early retirement. We’ve traveled the world for six months and want to make it a part-time reality. We’ve read from MMM that you should have 25x your living expenses before you retire. We believe that we could retire on $40,000 a year and are looking into living in southeast Asia. My wife, age 31, and I, age 28, would like to retire in 19 years. Right now, we struggle on what to do with our financial advisor, existing and future investments, and debt. We originally thought our financial advisor had our best interests in mind, but we don’t feel they align with our goals. We are reaching out to learn from someone who understands our goals and has conquered it.
Our Gross/Net annual family income: $160,000/$110,000
Our monthly family spending: $3,500-$4,000
- $5,127,14, 4.5% fixed
- $37,222.73, 5.625% fixed
- $5,700 in cash
- $82,572.08 in IRA’s
- $10,496.92 in Roth’s
- $76,719.83 in Joint Investments
Our concern with our current investments (Joint, IRA’s, and Roth’s) are that the expense ratios range from .5% – 1.9% (see attached spreadsheet for a breakdown). Each of these A-share funds has a 3.5% front load fee. We have read about index funds having lower expense ratios and think we should move most of our accounts over. We want to be growth-focused with 90-100% of our investments in index funds, but we are not sure about the distribution between U.S. and international index funds. If you were in our shoes, how would you allocate the existing investments into index funds?
We are also looking into reducing our taxable income by maximizing contributions to our 401k IRA’s and HSAs. Both of our employers offer a 401k and 401k Roth, but we aren’t sure which type we should invest in. What would you recommend? We are looking into the expense ratio of each employer’s plan. If these fees are too high, would you consider putting them into index funds instead?
Outside of our work we have both have an IRA and a Roth individually. Right now, we are questioning whether to move these funds. Do you have any thoughts on companies that manage IRA’s and Roth’s?
We are debating about continuing to invest in our Roths as we have read a few articles that made a compelling case for us to take those funds and invest into index funds. The main reasons being we are currently in a higher tax bracket than we will be when we retire and the 3.5% front load fee. Do you believe we should be maximizing our contributions into our Roths?
We would love to hear your thoughts.
Not All Financial Advisors Are Crooks
But these ones are.
Most of the time, an ETF or mutual fund’s fees are expressed as an Management Expense Ratio, or MER. This is a percentage that’s taken off the fund’s value every year to pay for management, regulatory compliance, book-keeping, etc., and the lower the better. We’ve written about the toxic effect of fees on your long-term investment performance before, and that’s why the ETF’s we recommend generally have MER’s around 0.1%-0.2%.
What Stuck is referring to are front-load fees. For the blissfully unaware, these fees are a percentage that gets taken off your purchase right at the point of purchase, so if you invested $1000, only $950 would actually make it into the fund. I don’t write about these because honestly I thought those had gone the way of the dodo.
Way back when investing in the stock market was something only Rockefellers did, you could get away with stuff like that but nowadays these are exceedingly rare. So colour me surprised when Stuck send me a spreadsheet of the mutual funds available to him. Not only did they have MER’s of 1%+, but they also had front-load fees of 3.5%! Some even had front-loads of 5%+!
These. Funds. Suck.
Run. Don’t walk, RUN away from these guys. They have sunk their fangs into your retirement portfolio and are attempting to bleed you dry. Check out our Investment Workshop and learn how to set up an index portfolio yourself using low-cost ETFs. You have no hope of ever retiring otherwise.
401(k) or Roth 401(k)
Onto his next question. Stuck’s workplace offers a 401(k) as well as a Roth 401(k) plan. Which one should they max out?
But first, an introduction to Roth 401(k)’s.
For the uninitiated, the two major types of retirement accounts most people have access to are the 401(k) and the Roth IRA. The 401(k) is an employer-sponsored plan in which you can make pre-tax contributions directly from your paycheck. These contributions lower your taxes when you contribute, but you have to pay taxes when you withdraw from them. Roth IRA’s are usually individually managed, and your contributions are after-tax, meaning you don’t get a tax refund for contributing. But on the other hand, you can withdraw from it (or at least, the amount you contributed) tax-free.
Roth 401(k)’s are less common, and are a similar to a Roth IRA in that your contributions are post-tax. You don’t get a tax refund when you contribute. However, the plus side to them is that their contribution limit is much higher ($19,000 in 2019 rather than $6000 for the Roth IRA). This contribution limit is shared with the 401(k) plan, so that’s $19,000 total contributions to the 401(k) and the Roth 401(k).
There are also strange quirks in how Roth 401(k) withdrawals happen. If you have a Roth IRA that’s, for example, 80% your contributions and 20% investment growth, you can withdraw from it tax-free by taking the part you contributed out first. Only when that’s all gone and you’re left with the portion that’s from investment growth do you start having to pay taxes and penalties. For most early retirees, those rules work out just fine for them.
Roth 401(k)’s, on the other hand, calculate the withdrawal distributions in a pro-rated manner, meaning if you withdraw anything, that withdrawal will be made up of 80% your contributions and 20% investment growth, meaning you’ll be hit with taxes/penalties on the 20% portion right away.
Of course, you can rollover your Roth 401(k) into a Roth IRA after you leave your company, but then there’s a 5 year lockout period in which you can’t withdraw anything tax and penalty free. Unless, of course, you roll it over into an EXISTING Roth IRA that’s at least 5 years old, then it works.
ANYHOO, my point is that withdrawing from a Roth 401(k) is not straightforward at all, and there’s all sorts of stars and asterisks you have to be aware of. So that’s a downside.
So should Stuck max out their Roth 401(k)?
My opinion: No.
The major advantage of the 401(k) plan is tax deferral. Pay less tax now while your earnings are higher, then draw it out slowly in retirement by building a Roth IRA Conversion Ladder to get it out tax-free.
The only time it makes sense to contribute to a Roth 401(k) instead is when your current earnings are low and you’re expecting your income to be much higher later. Considering this couple’s pretty healthy $160,000 combined earnings, I don’t think they’re in this situation. I mean, if they’re expecting to get promoted and double their salary in the next few years maybe a Roth 401(k) might make sense, but who can predict these things? The only things we know for sure are that their current earnings are pretty good, and that in retirement their earnings will drop.
So max out your 401(k).
Let’s Math Shit Up
Now onto my favourite part: Mathing Shit Up!
Stuck wants to retire in 19 years. Can they make it? Well, let’s see.
To summarize, here are their top-level numbers.
|Income||$160,000 gross, $110,000 net|
|Expenses||$4000 per month, $48,000 per year|
So first of all, please pay off your debt. Your interest rates aren’t too bad, but there’s no need to hold debt while investing at the same time. So pay it off. Your bank account will thank you. If they do this, their starting portfolio will become $175,488.83 – $42,349.87 = $133,138.96.
Secondly, while they’re estimating a current yearly spend of $48,000, they mentioned they’d be retiring to SE Asia and living off $40,000. Speaking as someone who’s done it, retiring in SE Asia on $40,000 is totally doable, and with that budget you’ll be living in the lap of luxury, so GREAT IDEA, if I do say so myself.
That means that their FI number can be calculated using their post-retirement spending level, which is $40,000 x 25 = $1,000,000.
However, their savings rate while working must be calculated using their current spending level. Let’s figure that out now.
But before we do, we have to account for the fact that if they max out their 401(k)’s like they’re planning on doing, their net income is going to go up because they’ll be saving on taxes. Based on their rather gnarly current tax rate, I’m going to take a wild stab and guess they live in a high-tax location. For the purposes of this calculation, I’m going to assume NYC.
So if we plug in their income into a tax calculator and add in a combined $39,000 401(k) deduction, their net income goes up to $126,321.
Given their current $48,000 spending level, that makes their savings rate $126,321 – $48,000 = $78,321 per year, or an impressive 62%.
And with that, we have enough information to do an FI projection, which shows they can retire in…
So it looks like their goal of retiring in 19 years was wildly pessimistic. Turns out they can do it in about half that time!
But first, get thee away from those shitty advisors with their shitty fund with insane fees. Transfer your money out to a self managed account with Vanguard, and learn how to invest it yourself using our Investment Workshop. You work hard for your money, so don’t let so suit suck you dry any longer. That’s YOUR money, and it should be going towards YOUR retirement, not theirs.
And we’re done! Questions? Comments? Let’s hear it all below!
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