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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.
Hi FIREcracker,
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
Debt:
- $5,127,14, 4.5% fixed
- $37,222.73, 5.625% fixed
Investments:
- $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.
Best,
Stuck
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 |
| Debt | $42,349.87 |
| Net Worth | $175,488.83 |
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…
| Year | Balance | Savings | ROI | Total |
|---|---|---|---|---|
| 1 | $133,138.96 | $78,321.00 | $7,988.34 | $219,448.30 |
| 2 | $219,448.30 | $78,321.00 | $13,166.90 | $310,936.20 |
| 3 | $310,936.20 | $78,321.00 | $18,656.17 | $407,913.37 |
| 4 | $407,913.37 | $78,321.00 | $24,474.80 | $510,709.17 |
| 5 | $510,709.17 | $78,321.00 | $30,642.55 | $619,672.72 |
| 6 | $619,672.72 | $78,321.00 | $37,180.36 | $735,174.08 |
| 7 | $735,174.08 | $78,321.00 | $44,110.44 | $857,605.53 |
| 8 | $857,605.53 | $78,321.00 | $51,456.33 | $987,382.86 |
| 9 | $987,382.86 | $78,321.00 | $59,242.97 | $1,124,946.83 |
10 years!
Conclusion
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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I agree. Drop that “advisor” like a bad habit.
Move your investment to Vanguard or Fidelity where you don’t have to pay those outrageous fees.
I had one of these “advisor” when I first started investing. Their main goal is to make money from commission. It’s a conflict of interest. Your investment is secondary to them.
At least find a good financial advisor who doesn’t try to sell you crappy investment.
Good luck.
I don’t totally agree with your math although I think it is only a year off. $40,000 a year now is going to be worth a little less in ten years. At the normal inflation rate of 3% it will take $54,000 to live the same way in ten years in the US. Some Asian countries have higher inflation and some lower but 3% is probably a fair estimate for the region. So the FI target needs to be $1.34 Million instead of one Million. But that is still only ten years instead of nine.
And where did you get your numbers from?
Totally agree about that investment advisor. Drop ’em like a hot potato. There’s absolutely no reason today they should be shilling front loaded funds. Crooks, like you said.
More than likely that advisor earns money for every investor they put into those crappy funds.
This is exactly why every investor truly needs to educate themselves. There’s absolutely no-one you can truly trust with your money except yourself.
A lot of businesses are built off of the idea that the average person WON’T educate themselves on these matters. It’s the reason stocks and investing in general are kept under a veil of mystery… to keep everyone from firing their advisor.
Oh man, you think that’s bad. My brother has a financial advisor that is straight robbing him. 5.75% frontload on all of his funds, plus 1%+ expense ratios. Then his individual stocks and ETFs are 2% commission to buy and sell. And I have no idea what other fees he’s paying because the stupid fee document is 50 pages long.
I recently wrote about his situation on my blog, but hoping I can get him out of it – he never listens to anything I say. And he keeps saying this financial advisor is his homie.
I’m on a very similar path to “Stuck” — also 28, and currently maxing my 401k with the goal of a million in about 10 years and the hope of traveling full time. Perhaps because I currently work in the medical field, the biggest concern I have (and that I think “Stuck” should have) is the potential cost of medical insurance/medical care in 10 years, 20 years, 30 years, etc. I know you guys have state-sponsored Canadian medical care, which is awesome, but I’m wondering if you or anyone else has thoughts about how a U. S. citizen should plan for the possibility of something like cancer, heart surgery, etc., which could really strain a person’s savings if they didn’t have good insurance. In my job I see people getting financially decimated by unexpected medical problems almost every day, so I know it’s a real possibility without adequate planning — especially since western medical costs are generally rising much faster than overall inflation.
My wife and I are lucky to have been in pretty good health so far, and her employer generously drops a couple grand per year into an HSA; we’re maxing it out and investing all but our out-of-pocket max in VTI. As a result, we anticipate a healthy six-figure balance when we hopefully retire in eleven years or so.
We’re both maxing out our 401k plans but NOT our IRAs, because the HSA is at least as tax-advantaged and more useful in case we incur significant medical costs before age 59.5… and can double as an IRA at age 65 when we can pull from it penalty-free (only paying taxes) for any reason.
Full disclosure: we’re doing this instead of having kids or owning a house with more than one bathroom or driving cars newer than fourteen years old.
They can still open a ROTH IRA now with a minimal amount of money so that it will satisfy the 5 year rule when they want to have access to it.
Hey guys, great stuff and I wish you were both around about 40 years ago when I got stuck having to pay front end fees and management fees as well. Some of the investments I was in also charged a fee to get out of as well. Little wonder why I stopped putting money into the market till I stumbled on your TV interview about your early retirement. Later after joining your website you mentioned {4 years ago} a company that you had started your journey with. I had a meet with them and although I still am paying a 1 % management fee I am really satisfied with the service and advice they have given. Thanks for the great work you are doing. I look forward to your articles each week!
no one really has to be stuck with a crappy investor, when they can become a “travel blogger an affiliate marketer,” and create content putting themselves in the position to potentially make money online 24 hours a day to three years after starting their “travel blogging side hustle.” and the beauty of side hustling and blogging using affiliate marketing is, anyone can become a “side hustle millionaire.” Don’t you agree affiliate marketing is less risky than investing? 🙂
I agree fees should be part of an investor’s criteria for investing, especially for millennials in the accumulation phase with long time horizons. However, most millennial investors didn’t have investments in 2000, ’01, ’02 when markets were down 3 years in a row. They also may not even remember the crash in ’08 and if they were investing 11 years ago, it likely wasn’t significant amount. The worst year for U.S. markets over the last decade was last year and down only about 6% which was quickly recovered. The last 10 years have been easy for Investors. How will they do during bad times?
Fact is people are emotionally tied to their money, especially when it accumulates to an amount worth protecting. Read any article about behavioral finance and you’ll see why average investors don’t have anything close to average market returns. It’s not because of fees, it’s bad financial decisions. Isn’t it possible an advisor could make up for their 1% fee for advice (amongst many other things they do for clients) by helping someone make good decisions?
If my car breaks down I could probably find a YouTube video on how to fix it. Maybe I get it right, maybe I save some money. But it still costs me time and could cost me more money and more time if I got it wrong and eventually need to get it fixed by a mechanic.
What’s the price for peace of mind?
Sincerely,
Biased Financial Advisor
I think it’s a bit disingenuous to suggest that Wanderer and Firecracker are against having an independent financial planner, given they have written widely about their relationship with their planner Garth. But fair suck of the sauce; 3.5%+ front end fees plus 1%+ MER’s in this day and age is just outrageous and should be called out. A real financial advisor should have a fiduciary duty to act in their clients best interest and the one outlined above is a clearly not. I have in the past worked with a fee for service advisor, and their advise was useful – but after many years, I have educated myself and believe that no one has my best interests in mind more than me!
I see all sorts of holes in the logic here. What if the tax code most likely changes in the next 10 years? Roth conversion isn’t a “tax free” method of withdrawing your pre-tax assets. Why would you rush to pay off low interest debt if your ROR is greater than the interest rates? Investment expense is part of working with a financial advisor. If you don’t value the advice, don’t pay for it. If you need advice, there’s no such thing as a free lunch. Evidenced by the unsolicited commissioned links at the bottom of the article.
For most people the barrier for dropping the advisor is confidence. Here is my advice for this couple on how to move forward:
1) Kill the debt, you have the cash. No doubt there.
2) For the next year follow the investment workshop as it was written, over 52 weeks. Any new money that you planned on investing goes according to the workshop.
For this year of the Workshop, keep what you already have with the advisor with them. Why?
It is under 200k and you already paid the front-load fee anyway, so you only pay the MER for this year. No small change, but keeping it there for one year while you get your bearings and confidence with DIY investing won’t set you back too much.
However, the main downfall of DIY investing is the psychological aspect. It is hard pulling the trigger with 200k that you all of a sudden need to decide what to do with, and so many people new to investing get paralysis-by-analysis and end up doing nothing with it.
Also, during the year of doing the Workshop you will set up your accounts, spreadsheets, read about different ETFs, get the competency and confidence with managing account types, preparing your taxes etc. If you decide up-front to take out all your money you won’t have that mental infrastructure yet in place and you will find that, once again, you need help. So, wait until you are competent before pulling the money out.
3) At the end of the year re-evaluate how you feel about DIY, and if you are confident, pull the money out of the advisor.
Never underestimate the psychological aspect. I am confident that I can do my own investing, but most of our money is with an advisor. In my case it is because by partner is not confident, and not interested in learning or doing any of it. The fee I pay is worth it for me for reducing marital conflict and stress. There are many reasons for choosing DIY vs. advisor, the bottom-line is not the only one.
NewB Investor:
Very solid and well thought out advice. What a great plan for them going forward.
It does take “awhile” to gain confidence in your ability in any endeavor in life. This plan keeps their currently invested (and already front loaded paid for) money working while they train their investment muscles. The additional higher expense fees over the year of training can be considered their educational tuition. Sure, this plan is not optimized for money spent, but even with the additional fee costs over the schooling year, they will still be able to retire way sooner than originally expected, with the benefit of having the confidence they can indeed manage their own investment portfolio going forward.
The key will be having the intestinal fortitude to never panic but remain invested in down markets. 😉 Having a “comfortably sized” cash cushion helps tremendously; only they can determine what size of cash cushion provides the comfort they need to ride out a down market without selling their portfolio shares. My cash cushion is probably a bit larger than it needs to be, but it helps me and my hubby sleep at night. 🙂
Just curious if you’re one of those people that live off of the interest of $1m or more with no job. Is that you?
Dnn:
I’m curious as to why you are asking. Would the answer to your question make our comments more or less reliable / relevant / relatable?
My definition of a cash cushion is the ready cash you have available to fund your living expenses when other sources of income dry up. Many experts recommend 6 months’ worth of living expenses. Many people have not been able to save up even one month’s worth of living expenses. For our own peace of mind, we try to maintain a minimum of 18 months’ up to a maximum of 3 years’ worth of living expenses. We chose these durations because I read somewhere that recessions / market downturns typically take 18 months to 3 years to recover from their low to their previous high. Having a plump enough cash cushion means we would not have to sell off any of our investment shares to cover our living expenses when those shares would presumably be at much lower price than when they were purchased (i.e., don’t want to be in the buy high, sell low position).
For the record, no, we do not have a large enough cash cushion to live off the interest from that.
Since we are both retired, we need to carefully manage our stock and bond mutual fund investments. The income streams from those sources (i.e., dividends and capital gains) provide ~60% of our living expenses. The remaining ~40% comes from hubby’s Social Security check (~20%) and the pension (~20%) earned from his working a union job 6 days a week for 33 years. Our investment accounts were originally funded using my employer based 401(k) and a VERY generous 5 year period certain pension payout earned through my nearly 29 years working as a software engineer for a large aerospace company.
About 6 months before my retirement, we started funneling our investment fund earnings into our cash cushion rather than reinvesting them. We also put my last three pension checks into the cash cushion rather than into our investment funds. So we have a pretty healthy cash cushion to help us through market bad times if our investments stop paying dividends and/or capital gains. Now my only problem is not raiding our cash cushion when dividends / capital gains do not sufficiently cover our lifestyle inflation lapses!
Thanks for that insight. 🙂
Clarification re: “About 6 months before my retirement”
I meant to say “About 6 months before my last pension payment”.
My employer offered a wide array of pension payouts; the 5 year period certain option paid the largest amount of money over the shortest amount of time (I think per IRS rules the payout has to be at least 5 years?). Of course, then the retiree (um, me!) must live off the earnings from those pension payments … thus this retired 60 year old reads a blog written by a couple of Millennials. 😉
NewB Investor, thank you for this articulate game plan to break up with my financial advisor. As an aspiring (though cautious) FI being, I’ve been searching for an answer of HOW TO Break Up with my Financial Advisor (who charges 1%+ MER on my Roth IRA and Personal Investment Account). I always felt like the 1% was a small price to pay as I was completely financially illiterate aside from knowing that I “should” be contributing to a Roth IRA and that I “should” have an investment account to assist in a down payment for a house, but didn’t have the discipline to educate myself. Since initiating my journey to FI, I’ve been introduced to new perspectives (THANK YOU from the bottom of my liver Fire Cracker and Wanderer!!! MMM, OLD Finance, BiggerMoneyPockets, Ramit Sehti, and the Mad FIentist), math, and strategic living which have influenced my paradigm and shown me the light. I now understand that a “traditional” home purchase isn’t in MY best interest. I’m in the 3rd week of the Investment Workshop and completely stoked on committing to living the life I’ve been diligently waiting to live LATER. I have some additional questions and am all ears to anyone who can offer insight. When it’s time to BREAK UP with my Financial Advisor…is there a more strategic time than another to do it? Since I have $0 debt, 67K in my Roth IRA and 47K in my Personal Investment…is the PI account like the Roth in that I need to “roll it over” directly into another investment account (say Vangaurd or Fidelity) to avoid “capital gains” tax? If there is no such thing as “rolling it over” for a PI account, is it better to take it out in a lower income year to avoid taxes? Even though I plan to put it straight into the market…like low cost ETF’s in my recently opened Vangaurd account (thanks to the Investment Workshop) for example.
SE Asia.? Bkk o r Vietnam boonies. It matters as far as how much $40,000 will go.
Stuck’s situation is relatable for us, we too feel stuck, but not entirely in this way. Cheers to only 10 years until FI/RE!
We only have $50k invested, but have both received significant raises and will be investing $50k within the next year. We do not want to be charged the “management fees” (currently 1.40%) on the increased contributions on top of the expense ratio fees.
Currently, our advisor has us in Guidemark and Vanguard ETF’s, but the Guidemark shares expense ratios range between 1.18%-1.70% and, not to our surprise, he insists for them being kept (for obvious reasons) – “it helps boost our portfolio, beating the S&P 500,” which it has, right now.
We approached our advisor about self-managing and as expected, he does encourage Index Funds and ETF for passive investing if one were to self manage (he’s a nice guy), but warns about potential “estate planning” and “tax law” mistakes that he can provide collateral for. We suspect this is a very real reality we need to learn more on, but we sense this is a fear tactic to keep us under his wings. If we may, we are curious of your thoughts.