Answers to several reader questions about investing efficiently for your financial freedom. Learn more about low-cost broad-based index funds or if you should max out your 401k early.
- Recent market volatility has provided an opportunity to test your investment resolve.
- Any low-cost broad-based index fund is a solid investment strategy, VTSAX is not the only option.
- Understanding the difference between Roth vs traditional options can help you plan your tax-efficient retirement.
- Fee-only advisors that act as fiduciaries in every area can be helpful. However, many financial advisors are not fiduciaries and have an assets under management fee structure.
- Take the free FI 101 course.
- Find a local group.
- Sean Mullaney, The FI Tax Guy
- Danny Kenny, Financial Planning For Financial Independence
- How To Write An Investment Policy Statement–The White Coat Investor
- How to Fund Your Child’s Roth IRA And Other Tax Optimizations With The FI Tax Guy
- Annual CFP Roundtable 2017 With Kyle Mast And Danny Kenny
- How To Open Accounts With Vanguard, Fidelity, And Schwab
Table Of Contents
- Do You Realize What You Are Doing?
- Stock Market Volatility
- Index Funds
- Financial Advisors: Fees And Taxes
- Roth Vs Traditional
- Jared’s 401(k) Advice
- ChooseFI Local Groups
- Book Winner
Do You Realize What You Are Doing?
[Jonathan] Congratulations, you made it to the weekend. This is your Friday roundup. Welcome to ChooseFI.
All right, everyone, thanks for being here today. Excited to do a Q and A episode. And I thought, what I mean by that, is that every week we get hundreds of questions that might actually be on the lower end, it might be approaching a thousand questions that we get and we aggregate those. We look for patterns and we figure out how we can best serve you with this Friday show. Sometimes that looks like diving into an episode. Other times it looks like actually taking those questions that you’ve sent us or asked on our Facebook group and bringing them to the show so that we can then, you know, bring out our feedback and then bring in feedback from our experts. And help me with this. I have my cohost, Brad here with me today. How you doing, buddy?
Stock Market Volatility
[Jonathan] Oh, not much. You know, I think if I was going to add anything, it would be this week’s been kind of a volatile week in the stock market. And it’s been one of those opportunities to kind of test your mettle, you know, if you will, or really test your mindset. See, I think that’s one of the things that you hear out there, is that, oh, it’s great to be an individual investor, but, you know, when the market goes down, that’s when you find out what you’re really made of. And I don’t know if the market really did go down. In fact, I think it actually went up. But I think we all thought it might go down. And it was interesting to kind of see some of the feedback from people in our community.
[Brad] Isn’t that interesting? I think we all thought it might go down. Right, get your stupid little human brain out of this, I think is really the moral of the story here.
[Jonathan] It’s at or near the top. How could it keep going up, it can’t keep going up?
[Brad] See, the last 10 years. But. But all jokes aside, I’m susceptible to this. Jonathan is. We all are. It’s just the way that it works. You need to plan ahead of time to somehow steel yourself for this inevitable point of emotion that, you know, is going to happen. Like, you know, it is going to happen. So, I mean, do you set up systems? How do you think through this, Jonathan?
[Jonathan] I frankly have no fear. Like, this is the craziest thing. Like, I, apparently there should be emotion. My only emotion is, oh, there’s a buying opportunity coming.
[Brad] Well, OK, let’s dove into a buying opportunity coming. So like. What does that actually look like? So do you have cash set aside like, what do you mean? How does this work?
[Jonathan] Yeah. So basically, you know, when we get paid, whether it be on the 1st of the 15th of the month, that’s my normal period of investing. Right. But if you think that if the market is acting volatile, if the market is acting volatile or it starts to go down and you’re watching it go down, I get greedy. Like I’m like, is there any way that I can get this money faster and I can get it invested faster? And there are solutions for that. I mean, that’s probably a separate conversation, but I think the larger point is I saw someone in the Facebook group saying, oh, the market’s volatile. I think I need to take my chips off the table. I want to sell now, right before it goes down. Am I crazy for thinking that? Or the market has gone down by four or five percent? I want to sell right now before it goes down any farther. And I think that is really the point at which this conversation becomes really valuable.
Mine is just I’ve completely shifted–I don’t even know how to sell. Right. That’s the largest point. Like for the vast majority of our audience, they are in the accumulation wealth building phase. You don’t need to know how to sell right now when you’re buying a low cost, broad-based index fund, you’re buying the market when the market’s doing great. Great. When the market’s doing poorly. Also great because we’re buying it on sale. That’s all I know. I don’t have to worry or think about selling. And so when someone’s in their mid 30s talking about taking money off the table, I’m just thinking why? Because the market’s going down. This is where you want to put more in. You’re putting more in and you’ve got time on your side. Why would you do anything else?
[Brad] Yeah, it’s almost like cliche at this point about stocks are the one thing that people do not want to buy when they’re on sale. They flip out. Anything else, if you went into a clothing store and bought a shirt and it was 70 percent off, you’d be doing backflips. Right. But if the stocks go down 5 or 10 percent, people are fleeing. So it’s this. Listen, this is hard. I mean, nobody. So, I mean, we’re not trying to make light of this, but nobody likes to see their money go down.
A friend was joking with me. I went out with them on, Laura and I went out to Happy Hour with them on Friday night. And the stock market had just gone down 3 percent. And he’s like. So you lost five fingers plus in net worth today. Right. Right. He’s like. You know, he threw out a number. I’m like, oh, wow, that’s crazy. And I have to say, I was very proud of myself that I didn’t even realize it. I had no idea that the stock market went down. I didn’t care. And even when he told me, I was just like, well, it happens.
I mean, that is a crazy thing. I lost more in one day than I had made in a year when I got my first job, but yet I didn’t freak out. And that’s because we have educated ourselves and we’ve set up systems to basically not panic sell. And I think that’s really, really important. So what I believe is I’m looking at this as a 50 to 70-year project. I’m not looking at it as what’s going to happen next week or next quarter. So my 70 year project is to be wealthy, to accumulate wealth for generations, essentially. And if I’m going to flip out over what happened on a random Friday in January 2020, that’s not really the best plan to get me there. So I think it’s where did the white coat investor talked this through? What is the investor policy statement or something, do you recollect that?
[Jonathan] Yeah. So this is basically for people that would have a tendency to be emotional and maybe even those that don’t.
[Brad] Which is all of us essentially other than Jonathan, maybe.
[Jonathan] No I think I’m emotional, but my emotions tend to a little bit of greed as opposed to fear, right? Yeah. Anyways, with the investor policy statement, the idea is when you are in a great place, when you’re thinking logically, when the market is stable or the market is going up, but ahead of time, you actually write down what your investing goals are, right? What do you do when the market’s going up? What do you do when the market is going down and he has an entire article on it. We can link it up in the show notes for the episode. But basically what you do is you think through those different variables and you map out, well, what if the market has a 10 percent correction? What if the market goes down by 20 or 30 percent? What if the market goes 50 percent? And underneath each of those questions, you basically lay out what you would do in a logical, rational state. And then when it’s actually happening, you go to that piece of paper and you follow the instructions you left yourself. You don’t deviate from the plan, right, because you’re making better decisions when you’re in a logical state.
Again, it’s when you’re talking about an individual stock, there can be a lot more fear attached to the market returns, right? You just really don’t know. You know, government regulations can change something. There’s a huge lawsuit. There’s a crash that kills many, many people. And there’s all and there’s planes that are grounded. You just don’t know the future of an individual company because there’s too many variables. But when you’re talking about owning large swaths of the economy and you talk about owning every publicly traded company in the United States, you own them all. And some of those companies will go to zero. Right. But it can only go down to zero, whereas other companies can go they can double one hundred percent to 12 percent, 1,000 percent, 40,000. But there’s no upper limit. And so that will inevitably drag your returns up over time because, again, you own them all.
That’s the assurance. And if you’re not worried about something going to zero, because can’t. If it goes to zero of your investment when you’re owning all the companies. Right. Total stock market index fund, when you own all the companies, if it goes to zero, you got bigger problems than your bank account, right? We are talking straight zombie apocalypse. It’s not good. You’re not getting into your bank account. Your money isn’t worth anything anyways. But since you can’t bank on that plan around in this sort of manner anyways, I just don’t worry about it. I don’t have any fear. I have my I realize where I am in this game right now. I’m in a wealth accumulation phase. I’m building wealth for myself and my family. And I don’t intend on needing this money in the near future. You know?
That is the vast majority of our audience they’re on this path, so you don’t need to worry. I don’t even, I really I’ve never sold anything. Why would I sell something? I’m in it for the long term. And then when you’re talking about someone that is now, you know, maybe they’re inside of five years of retirement. Right. Or they are actually at retirement. It’s a different conversation. We can parse this out. We can have that conversation. But if an individual’s in their mid thirties talking about how they want to get money off the sideline because they feel like the market is at or near the top, it’s always at or near the top. It’s spends 90 plus percent of its time at or near the top. If you had said it’s at or near the top three years ago and taking your money on the sidelines, you’d be looking back with your hundred fifty thousand dollars as it goes up another 20, 30, 40, 50, 60 percent and saying, oh, I wonder if I should wait for it to drop before I get back in.
When your timing in the market, you’ve got to figure out twice. So in my end, my little calculation, you know, is different when it when it’s I have my regular times that I invest. And then if I see volatility where it’s going down a little bit, I’m like an easier way I could get in a little sooner. I don’t know if that volatility is still going to be there on my payday. Like that’s it. Is a much simpler calculation, but it does not involve selling at all.
[MK] And Jonathan, I would add onto that when Brad was talking about connecting with that friend and saying he didn’t realize that the market went down, you also didn’t realize those losses because you didn’t sell. You know, you didn’t lock in those losses. That money can still grow and grow and grow. So to the point that you made of. Yes. This is a long term game. You only realize the loss when you hit the sell button, when you hit the panic button. You have not actually lost a thing until you decide to get out. So that money is going to continue to grow. And actually, it’s on sale.
[Brad] So MK okay. I love the word play there to the you didn’t realize and you didn’t realize. I’ve been listening to a lot of the Hamilton Broadway musical.
[Jonathan] How did you work Hamilton into this conversation?
[Brad] Come on. It’s the amazing wordplay like that is M.K.. That’s brilliant.
[MK] As the resident author. I’m here to do that.
[Jonathan] So, Brad, did you hear that Disney picked up Hamilton?
[Brad] I did. Yeah, I think. I think they paid 75 million dollars for the rights, essentially to Lin Manuel Miranda to have a Hamilton movie next year. So, man, Disney, they just keep on seemingly they keep on winning. It’s remarkable.
[Jonathan] Well, yeah. So I guess that’ll show up on my Disney Plus in the near future here. I’m loving my old 1990s Disney cartoons. I’ve got gargoyles in the background of my house.
[Brad] Yeah. We’ve been rocking the Disney Plus recently too. I think it was 60 dollars for the year. And I’ve watched all the Star Wars movies. I’ve seen the Mandalorian. It was like the best sixty dollars of entertainment I’ve spent in quite some time. But actually, real quick I wanted to mention. MK, aside from your brilliant wordplay, they’re so realized gains or losses. The reason some people are probably, shrugging here, wondering what on earth I’m talking about.
So in essence, when we said we lost money. Right. That is for 99 percent of time. It’s on paper. These are paper gains and paper losses until you actually realize them, which in stock parlance that’s you’re talking about selling them. Right. So the phraseology is there unrealized gains or losses. They’re essentially paper gains or losses until that moment when you realize them, which is you actually make the transaction to sell. And at that point, that is the moment of truth. That’s the moment of truth when you realize the gain or loss.
So essentially, it’s just looking back at your original costs. There’s some, you know, people will be sticklers here for some dividends get factored into basis and other things like that. But in essence, for most people, it’s your purchase price. Let’s say you bought it for 100 dollars. And the fair market value of it that day is one hundred and twenty. You have a 20 dollar unrealized gain on that share because it’s now 20 dollars above. So that’s a gain. If it was 80 dollars, it would be a 20 dollar unrealized loss until you actually realize it and sell it. And then that is what ultimately occurred. So it’s then a 20 dollar realized gain or a 20 dollar realized lost.
[Jonathan] Anyways, you know, I think it’s actually interesting because while we really could with no confidence. I don’t, I cannot predict the future. I have no idea what’s going on with any particular company. We don’t recommend individual companies on the show. We don’t have the qualifications to do that. The show is for entertainment and education. But we can’t see the future here. Which is why we always talk about low cost, broad-based index funds. Right. Like buy the entire market, buy them all. We can at least tell you how to keep up with the market. And that is more than good enough. The vast majority of investors fail to keep up with the market. But I do feel like inside of our community. There has been unnecessarily some dogma focused on one fund when we are responsible in part for are putting too much emphasis on this, but I think we’re going to try to rectify that situation today.
[Brad] Yeah, yeah, there’s a lot there, Jonathan. This actually was spurred on by a Facebook post, a really great Facebook post. I hope I’m pronouncing her name right, but Kathor, where she said, why is VTSAX so popular here? It is a good index fund for sure, but so is FXAIX and FSKAX, which I’ve subsequently learned are the Fidelity 500 Index Fund and the Fidelity Total Stock Market Index Fund. She said, what am I missing? I did the search below today and cannot find a good reason as to why I would pay seventy five dollars to buy VTSAX as a Fidelity customer. While there is a similar index fund with no fees or minimum or minimum trading volume. Tell me more. And I think she’s spot on.
I mean, my response and I’m not sure that it came across as clearly as possible was you wouldn’t pay seventy five dollars if you were a Fidelity customer. You had a Fidelity account and they’re trying to charge you seventy five dollars to buy VTSAX, which is a Vanguard Total Stock Market Index Fund. You simply would not do that. She’s absolutely right. There are wonderful total stock market index funds, S&P 500 index funds at Fidelity, at Schwab, at all these other places.
And so I think it’s really important here that we’re saying we are not crazy about one particular fund and one particular company. Obviously, Jonathan, we’ve talked a lot that we like what Vanguard stands for and that’s why we talked about VTSAX before. But what we truly believe in. And again, this is not investing advice. This is not me telling you to buy a particular thing. But what we believe in is a broad-based, low-cost index funds. I think the broader the better personally. So I personally like total stock market index funds. But what really matters is the expense ratio.
But what we believe in is broad-based, low cost index funds. I think the the broader the better personally. So I personally like total stock market index funds. But what really matters is the expense ratio.
Right. Like that is the key because we’ve talked about just how destructive fees can be on your overall investing return. And again, like I talked about 10 minutes ago, this is a 50 to 70-year project. Right, to get wealthy. This is not a oh, that tiny little fund doesn’t matter in the next year because this fund is hot. Like, I don’t look at nonsense like that. I look at what gives me the highest likelihood of being successful in a 50 to 70-year project. And for me, keeping my expenses ultra, ultra low is the best way to get there.
[Jonathan] Yeah, there’s a lot there. So, first of all, what was someone like for this lady in this particular question? I am with Fidelity and they’re trying to charge me seventy-five dollars to purchase VTSAX because I hear from the FI community that VTSAX is where it’s at. And your point? No. That’s crazy.
But what you can do is that Fidelity has their own total stock market index funds. And as it happens, it’s kind of interesting for various reasons, both of us. I’m uniquely qualified to provide this information have ended up with funds at Fidelity, at Schwab, and Vanguard. Right. So I actually have funds with each other so that now I can tell you from a place of authority that you can get total stock market index funds at each of those, all of them in-house, which you will likely get the most favorable rates on.
Fidelity is saying, well, yeah, you can get a competitor’s mutual fund through us, if you want, we’re going to charge you for it. Or you can just use ours and we charge you no commissions, no fees at all. So I’m just gonna give you the ticker for theirs. They’re the one that they market is being very similar to the Vanguard Total Stock Market Index Fund, except with no basis points, no fees at all is FZROX. That is their total stock market index fund.
Schwab has one as well and theirs. Their ticker on theirs is SWTSX. Now in this post she actually mentioned a couple others and those are entirely reasonable as well. There may be some slight nuance between how they figure out which funds are in there, but largely any of these will give you very, very similar results. I think one thing that actually is interesting to kind of talk about when we were discussing these different types of funds and we’re talking about index funds versus maybe actively managed funds, etc., is we’ve spent a lot of time in the past. I won’t spend too much time here is that we’re avoiding fees because fees are guaranteed. And so used to be if you look back like 10, 20, 30 years ago, you would very commonly, it would be very common to see at least a 1 percent expense ratio plus maybe some sort of a 1 percent assets under management fee. I mean, 2 percent or more. And now, thanks to leaders in the space like Vanguard that are owned by their investors, it drives those fees lower. So when they make profit, that profit is actually used to drive the fees lower. And that’s how we’re ending up with expense ratios like 4 basis points. Now I understand that’s all that’s that’s that’s legalese investese. Right. So like what that means practically, though, is, Brad, you can run a calculation 2 percent off. Like I say, you have a million dollar portfolio. And the old model, it was a 2 percent.
[Brad] Yeah, that’s twenty thousand bucks.
[Jonathan] Twenty thousand dollars is what that would cost you each and every year. And when you compound that over a period of 20, 30, 40 years, it actually is up cutting your portfolio in half. In perspective like 4 basis points, which is Vanguard is really one of the first to get there. It’s costing you $400 on a one million dollar portfolio. So if you only have two hundred thousand, I say only if only have two hundred thousand, it’s costing you 80 bucks a year total. Right. That’s insane. It’s insanely low.
And then what that has done is that has signaled because Vanguard is getting incredible market share. Massive amounts of money was moving out of assets under management and into these low cost, broad-based index funds. Fidelity and Schwab were feeling a little left out, right, and they felt the need to compete and offer these as well. And theirs have gone even lower. Schwab, I believe, was that like 3 basis points, maybe even lower. Now Fidelity went straight to the heart and you had a 0 basis point fund. And there’s some nuance here, some funds are maybe better and others in small ways, but your results are gonna be largely the same. You’re gonna keep up with the market.
[Brad] And Jonathan, basis points. You said that a bunch of times. Until maybe about seven years ago. I had no idea what this meant. I know I can vividly remember the V.P. of my department mentioning basis points. I’m like, what on earth are you talking about? It’s essentially just a hundredth of a percent. So in this case, if Schwab has three basis points as their expense ratio, it’s 0.03% for the expense ratio. So that’s three basis points. It’s just fancy jargon in essence, but you will hear it a lot. So just like anything, it’s important to educate yourself on the language of what you’re talking about and you will hear that a lot.
Financial Advisors: Fees And Taxes
[Jonathan] You know, it’s actually interesting, like once you understand this concept, it’s worth thousands, tens of thousands, hundreds of thousands of dollars. And M.K., I think you have a timely anecdote for us.
[MK] Yes. So this year, Jason, I said we want to have a better positive influence on the people in our lives who don’t know about FI, but we care about them. We want to see them feel more at peace with their financial situation. So his parents reached out last week and they have this prospectus on an investment opportunity.
Their local credit union financial advisor sent them to you, a financial adviser at an investment company because their credit union doesn’t offer investment products. And his Dad asked for advice and said this sounds like a great deal. Do you guys agree? Well, we looked at it. And first of all, there was a load fee of 3.75%. And then we saw that it was 72 basis points was the ongoing fee.
So we initially wrote an email that said this should be a crime, run, flee. And then cooler heads prevailed and we said, OK, let’s erase that. And actually broke down in an Excel document to say, OK, here is what they are saying, that they are going to charge you for this fund. And there were like five different funds that were like very similar. It was, it seemed like one of those things that were intentionally designed to confuse the average consumer, to make them think that they need this adviser to be able to justify the fee.
So we called out what they would lose immediately off of the load fee of 3.75%. And then we said, OK. Even if they agree to waive that with .72 % coming out every year as their fee. Here’s what’s going to happen over 10 years, over 20 years to your investment. And then we showed them a comparison to, OK, if you want a broad-based index fund. Here’s one that we found from this company that you have access to. Here’s with the same money would do over time.
So we tried to break it down for them to understand in real dollars, not just, well, this is a high fee, but to say, hey, look, this is why that it seems like, well, it’s not even a full percent. It’s still a lot that is being taken out for them not doing any work. So I think we found a way to explain it to them in ways that they would understand so that people like us who are deep into like the nerdy part of investments and FI, we could make it easier for them to understand. But it really should have been a crime what they were proposing. It was ridiculous.
[Brad] Wow. So, OK, what is the punchline here? How much money were we talking about? You saving them just by them asking you this question?
[MK] Just by asking this question. In 10 years, it was going to save them ten thousand dollars. And then what we found out is that this adviser said, well, if you put in five hundred thousand dollars, half a million dollars, which is ridiculous. Well, then we’ll waive the load fee so it like it saves. I was like, OK, but half a million dollars over 10 years like this is still a lot of money you’re going to lose. And like that, they’re going to try to sell you into another fund three months from now that they’re going to tell you is better. Like we had to explain to them like we’re the bait and switch was going to come as like they’re not waiving that load fee to be your friend. They’re waving that load fee because six months from now they’re going to switch you into another fund.
[Brad] Right. They have five hundred thousand dollars of your money essentially captive in their ecosystem. So. Right. Like when you’ve already bought into it.
[MK] And these are two people who are near retirement age, like his mother is retired, a retired teacher. His father should be retiring any second. I think he’s working because he just enjoys work and doesn’t want to, you know, putter around the house all day. But, you know, this is their nest egg that this person was asking for that they were going to be taking money off of. And I was like, no, they earned that over their lifetime.
[Jonathan] Right yeah. I mean, so highlighting so when we have people that want to be ambassadors, that want to start talking to friends and family and having these short, impactful conversations where you actually find out, well, what are you invested in and how much does it cost you to be invested in those like just being able to take or have a 10-minute conversation about expense ratios and assets under management fees like you should have been explained this.
But the problem is often the person explaining it to you has an incentive for you not to understand. Right. That’s a problem. That’s a problem. And so a lot of times people listen as you’re the ambassadors, you’re the one that has the opportunity to one, check your own funds. Take it to a spouse, to your parents and just have a quick conversation that does not need to be confrontational. It’s not a criminal investigation, but you can’t save them tens of thousands, if not hundreds of thousands of dollars over their investing lifetime.
And I think it’s actually worth pointing out, like what is an adviser doing for you? And you’re talking. And I want to say, actually, I want even back off it now. What is an adviser doing it for you? But when you have assets under management, you have someone managing your money for you because you couldn’t possibly understand this. You need someone that’s managing it for you. What are they doing? Well, the problem is, if they were just if they had you just keeping up with the market, it’s pretty boring. You don’t really need their expertise to just keep up with the market. It’s just what we just said that’s done. Right.
So then I mean, this person, this money manager has to beat the market or hedge your risk. Right. Hedge your risk or you make sure that you don’t sell when the market is going down, which is reasonable, you only realize the losses when you sell. But if the goal is to beat the market and this is what I hear, hey, I have a guy down the street, he’s only he can help me get an extra five points over the market like it’s on. You know, he’s got this thing locked. He’s got a system. Right. I mean, if it’s those types of conversation, you’re getting a person because you want do better than the market one, you’re automatically chasing returns like past performance is not an indicator of future returns. And two like the only thing is guaranteed is the churn. Right.
What I mean by churn is when you’re buying a fund like a total stock market index fund, you’re buying this fund that represents 3,000 plus companies. You’re buying at what the market prices and then you’re holding those. And then when you go to buy more, if the value of that fund has gone up, the value of those companies have gone up, you’re buying at the new share price for that fund.
You’re not selling, there’s no turnover, right? A broad-based low-cost index fund minimizes you hopping in and out of the market. You’re just buying more. But when you’re an actively managed fund, you have a team of people that work on that fund to decide when they no longer want to have a stock B in this mutual fund. So it’s hopping and their timing it for you to hopefully hedge your risk and give you better returns.
Now, whether or not they’re able to do that over the long term is a separate conversation. But what is guaranteed and implied in that is that you are buying and selling, and specifically selling stocks, individual companies inside of this fund, which means that every time that that decision is made, there is a taxable event that is being created. Right. So you may just feel like you’re buy and hold, well I buy that actively managed fund and I held it for as long as I can. But that’s not what’s happening behind the scenes. A team of people is selling and adding to your position over time, making it unnecessarily tax-inefficient.
[Brad] Yeah, you’re right. And it comes back to incentives, right? You always have to look at the incentives of the person making a decision. In this case, those investment advisors or whoever is behind the mutual fund, they are trying to show their brilliance in essence, which I’m kind of saying as sarcastically as possible here. But they have to prove why are you paying these fees to them? Because if it was just, OK, let’s buy the total stock market index fund, which I think is the best likelihood of success over time, like you would just go to the total stock market index fund, right? You wouldn’t pay them 72 basis points in MK’s case or 1 percent or whatever, it may be. So they are going to almost by definition be trading significantly and they’re looking at their total return in there.
So in most cases, investors aren’t savvy enough to look into, okay, what are the tax implications of being in this fund and what is the drag then on my return because of that? Right. So, Jonathan, in this case you’re talking about. And people don’t even realize this when those individual stocks are sold within that mutual fund there, there is a taxable event. And if this is a short term capital gain, that’s even worse. Right. Because it’s not at the preferential long term capital gains tax rates. So you’re paying tax on an ordinary income rate on this gain that’s in there just because these people who are running this fund want to just buy and sell, essentially. And so I mean that as crazy as contrasted with a total stock market index fund. And this is actually you and I were having a conversation about this morning just off line is how tax-efficient in this case we happen to be talking about VTSAX. But this is, of course,
[Jonathan] There is some love there.
[Brad] There is a lot of love. But it’s the same for all of these broad-based index funds is there are some dividends. And that if you’re holding these in a taxable account, that, of course, is a taxable event. OK, but. The VTSAX or whatever index fund, but in this case, they can’t say no. Company X, you know, Exxon, don’t give us a dividend. It’s just it’s part of business. So that naturally gets passed along and I get that.
But I can’t recollect a time where I’ve seen a capital gain distribution that’s taxable coming from one of these index funds, whereas if you’re in other funds, you will see both items. So you’ll see dividends and you’ll also see capital gains distributions and those even if you haven’t sold it, even if you haven’t realized it, they go on your tax return that year. So this is a real big deal.
It doesn’t seem like much because you’re just getting that 1099 and it goes on your return or you give it to your accountant. You don’t think about it, but that is actually what’s going on. This is a taxable event, even though nothing has changed for you. You haven’t sold any shares. You haven’t done anything. But rest assured, you’re being taxed on it. And that is the churn that you’re talking about. Jonathan, I think that’s a really important word that people are mindful of.
[Jonathan] So let’s say that the market returns eight percent one year and this active actively managed fund returns 10 percent that year. But there’s the expense ratios. And then there’s the assets under management fee, which is this headwind. Right. Which brings it back to that 8 percent. So now the kind of head to head.
But along the way, you know, they decided they wanted to hold a position on this one fund because it was a hot tip. And then for whatever reason, because of the next quarterly earnings, they wanted to get in front of it. They sold it. They got out of it like that, created the taxable event. And so it’s just times one hundred times a thousand, whatever. And so it’s not just those fees. It’s also the tax implications for you, which drag you back.
And it’s just, you know, with when you’re talking about finding the actively managed fund, you find that one fund and you’re looking at past performance, which automatically means you’re chasing returns, which makes it unlikely that they’ll be able to do that in the future because of the exact reasons that got them the returns in the past you’re buying and now you’re not buying in last year. Right. So but it’s very easy to say, well, here’s how you keep up with the stock market. Your accountant will love you. Let me just say this. I think it’s important to point this out. I’m not against having a person to help you with this. We are not against having a person to help you with this. So we use, I use an accountant. You are an accountant. I don’t use you because you said no. I have people on my team. I have an account that I love working with.
I think that many people would benefit from a financial advisor, would benefit, especially as you’re approaching your drawdown. You know, you’re on this glide path. You have resources. You’re trying to figure out how do you handle the drawdown. I would not pay them in assets under management fee. I absolutely would not. But there are great advisors that will charge their fee, only advisers. They might even charge your premium. I don’t really know how complicated your finances are. How much time you’re actually going to take. But I would imagine that the costs would run anywhere from one hundred dollars all the way up to a thousand dollars depending on the various levels of service that are offered.
Maybe it’s a front load where they help get your package together and it’s some sort of subscription model where they charge you a fee for that additional time that they spend with you. These are experts that understand their field and they’re providing their insight to you. And that’s an invaluable use of your time to go sit down potentially and have these types of conversations.
But I would want to make sure it’s a fee-only advisor, and I would want to make sure that their fiduciary in all aspects of their service, these terms are very important. They’re ones that we’ve learned from actual advisors in the industry and they kind of have given us this is the verbiage. A lot of times you’ll have this advisor that has a blatant conflict of interest. They’re fiduciary in one aspect, that they sell bloated insurance products on the other and they don’t really want to tell you where their incentives actually are.
So this is kind of the framework is not having an anti-adviser role. It’s rather make sure you understand how they’re being paid and that your incentives are both understood and aligned.
[MK] Absolutely. And I think the passion that we all have for this topic comes through when you hear us talking about it. Right. Like we’re getting excited. You can tell we’re a little heated. Like, how could somebody pay that fee? How could somebody charge that fee? And we know that there are bad actors in this space and there are very good actors in the space. And if you listening to this podcast, you are doing your research. You are asking those questions that Jonathan just listed. You know what you’re doing.
But it’s when you have that friend or family member come to you and ask you, hey, I’m looking at this adviser, what do you think? That’s where we want to make sure we’re dialing back some of our rhetoric and some of our dogmatic. How could you even look at that fee? They don’t know. And so that’s where us, as their friends, can start to educate them, to say, hey, you know, with this fee, you’re going to be paying this person ten thousand dollars a year for your money to sit there. Does that do you think that’s a good deal?
You know, have them learned the framework that we’ve learned. Have them learn to sit and do the math and find a compound calculator, find all those things that they’re going to need to make the best decision independent of what this person is telling them, because they may be making a great recommendation. They may not. And so we want to help to teach them to better understand and take more control of their finances instead of being the next person to tell them one thing. It’s not a telling like the financial adviser may be telling. We want to teach. And have that conversation with them yet.
[Brad] Yeah and M.K., you talked in there about helping educate family, friends, coworkers, and I think that is something we’ve all been kind of vexed by in the past. It’s hard to find that path to actually talk about this with people. And that, incidentally, is why we created. FI 101 here, it’s actually through our foundation.
So the ChooseFI Foundation just launched FI 101 for that express purpose. Right. This is Jonathan. Why it exists is it’s financial literacy it’s financial education. And we’ve packaged it in a way that it doesn’t require any knowledge coming in. You’re just you’re walking in as long as you’re following through these lessons. Watch the videos, read the information, follow through in the action steps. You’re going to walk out of that with so much more information. You’re going to have a base to move forward confidently. And I would challenge everybody out there who’s listening to this. If you were looking to get someone in your life interested, maybe in FI, in making better choices in their life. I think FI 101 is the perfect starting spot.
I think it’s a really safe way to get people interested and excited about making their lives better through their finances. And Jonathan, the easiest way to find it is just ChooseFI.com/FI101.
Roth Vs Traditional
[Jonathan] Yeah, I think so. And so just a second ago, I was pointing out how there are so many wonderful advisors out there. The problem with the industry is it’s so hard to find them. You just don’t know. It can be frustrating. Right. And so I know that whenever we do find a great advisor in the space, we try to highlight it for the community. And actually, I believe MK. We have a question teed up for today.
[MK] Yes. So Eric wrote in to ask with a question about his TSP contributions. So Eric said first, thank you, Brad and Jonathan, for the amazing information and content. I’m diving in headfirst. He said, I’m consuming the information available in the FI community as it pertains to retirement accounts. I was struck by the realization that while I’m deployed with the U.S. military, my tax-free income that’s being deposited into my TSP, traditional IRA equivalent, will be subject to taxation at withdrawal. I wonder how many other military members are unaware of how much more leverage they’d be able to apply to their TSP account if they were able to take advantage instead of the Roth TSP while deployed, avoiding any taxation whatsoever on this funds? Question mark with gratitude, Eric.
And so we sent that question off to both Danny Kenney, who’s our in-house expert, who’s a financial planner. And Sean Mullaney, the ChooseFI tax guy. So we wanted to hear from both of them. So Danny said that, yes, Eric is absolutely correct. When deployed, your income can be tax-free. And if you’re making TSP deposits, that’s exactly what would happen if it went into a traditional account where you’re taxed when you take the money out. Danny said that in this case, it makes sense to switch to the Roth TSP contribution while deployed.
And Sean wrote back as well and said that it really underscores the bigger discussion and understanding between traditional and Roth that a lot of people like to see the tax break now. So for those of us who aren’t deployed, who are, you know, generating the standard, a W-2 income, and we are saying, OK, we’re getting a tax break now. It’s coming up pretax. We still have to pay the tax down the road. So deciding whether we want to have that tax burden now with a Roth or later with the traditional. But if you’re deployed. Thank you for your service and enjoy the tax-free money. Hopefully, you can get that to a Roth TSP contribution and truly maximize that.
[Jonathan] Huge thanks to Sean and Danny for weighing in. We’ll have links to both these guys. That is a wonderful accountant and a financial planner in this space. I highly recommend that if you’re looking for a professional, either as a financial planner or as an accountant, you give these guys, give a shout out and go check out their respective websites. Let’s actually dive in and take a look at what the intent there behind Roth versus traditional. And even if you were to go at a higher level, you know, we could we’d only have a look at the TSP for the vast majority of our audience. We’re looking at maybe a 401k option. So Roth 401k versus a 401k.
The decision at its essence is, is our tax rate can be higher or lower. You know, now during our working years or in retirement and for the vast majority of the people listening to this, you are going to be paying more in taxes now, when you really can’t control your tax rate, it’s just subject to whatever your income is. As opposed to later when you literally get to decide how much money you want to bring home. Right. And we’re actually moving income from W-2 wages, which are pretty tax-inefficient to basically capital gains. And capital gains have so much more wiggle room for how much in taxes you pay.
The decision at its essence is, is our tax rate can be higher or lower. You know, now during our working years or in retirement and for the vast majority of the people listening to this, you are going to be paying more in taxes now, when you really can’t control your tax rate, it’s just subject to whatever your income is. As opposed to later when you literally get to decide how much money you want to bring home. Right. And we’re actually moving income from W-2 wages, which are pretty tax-inefficient to basically capital gains. And capital gains have so much more wiggle room for how much in taxes you pay.
In fact, I think there’s a quote on whether or not it’s a quote or not. It’s basically between Warren Buffett and his accountant. And Warren Buffett is basically saying, you know, my accountant pays more in taxes than I do. And I think they’re really referencing the percentage of the money that they make that actually goes to taxes. And what is behind that is basically that when you’re talking about capital gains, assuming that there’s not churn. Right. As you basically decide how much you bring home based on how much you bring home, you pay taxes on the capital gains that are attached that and capital gains tax rates are very favorable. That is at its essence, in my opinion.
[Brad] Yeah. And Jonathan, I just wanted to slow down or just a quick second on the mechanics of this, because some people out there don’t understand the difference between a Roth and a traditional 401k, or IRA, whatever it may be. So I think it’s very, very important just because you’re talking. The question is right, the ultimate question and you’re absolutely right about this. Like, is your tax rate going to be higher now or like you said, in retirement? But it’s really, in essence, when you pull this money out of those retirement vehicles.
Because what happens mechanically is if you are contributing to a traditional IRA or a regular 401k you’re getting the tax deduction in that current year. So let’s say you put in 10 grand into your 401k from your employee contribution. That’s ten thousand dollars that comes right off the top of your normal wages and does not get taxed in this current year. In this case, it’s 2020. All right. So if you made 50 grand and you contributed $10,000 thousand to your 401k, then your actual taxable income is only going to end up being forty thousand dollars on those wages. Obviously, then you still get further deductions on your tax return. But that’s outside the scope of what I’m talking about here.
But then what happens is so you got the tax deduction now, but when you pull that money out of this traditional, this regular 401k or a traditional IRA, whatever we’re talking about, it is a taxable event at that point.
So the reason why you would do that is if you believed that your current marginal tax rate, the tax rate that those dollars would be taxed at was higher now than in the future when you’re going to pull this out. And the reverse is true for the Roth. So the Roth the money you contribute this year, you get no tax benefit for it. So in essence, you’ve paid federal and state income tax on that money. This current year because it flowed through your tax return. In my hypothetical, you have the fifty thousand dollars of wages that ends up on your return. So even if you put that money into a Roth IRA or 401k there’s no additional benefit this current year. But what happens is it then grows tax free. And when you withdraw it, there is no taxable event. The taxable event happened at the front in this case in 2020, not 30, 40, 50 years down the road. So, again, you would do that in the opposite case when you thought your tax rate was lower now than in the future when you were going to withdraw it. So I just wanted that quick sidebar. Is that pretty much cover it?
[Jonathan] Yeah, that’s great. So if we’re talking Roth, you fund your Roth, you’re able to get a couple hundred thousand dollars in there either whether that’s through your Roth TSP or Roth 401k, a Roth IRA, whatever it is, it’s in a Roth vehicle. And then that grows to many multiples of that over the intervening 20, 30 years. Maybe you have six or seven hundred thousand, eight hundred thousand dollars, a million dollars. And that’s probably a stretch. But let’s say it happened. All that money is yours. You have to worry about taxes on it in any way, shape or form.
You know, when you get to that retirement age, fifty-nine and a half. That money is yours. And in many cases. Well, yeah. That money is yours without having to worry about the tax implications of it. And so many people say, well, taxes might change in the future. Tax rates might change in the future. So I’m locking in now. And really for someone that’s paying a zero percent tax, like in this case. This example does the individual is deployed. And while he’s deployed, he’s paying a zero percent tax anyways. Let’s lock it in. That’s an obvious choice.
Becomes more nuanced as you move up through the tax brackets. Maybe you’re looking at 10 percent tax or 12 percent tax. You’re like, oh, I don’t know. Maybe I should just lock it in now because I’m not really sure what it might be later. That’s a reason. That’s where the dilemma comes in. And then clearly, as you get past that, you know, 25, 30 percent. Beyond that, the incentive start to go the other way. And here’s why. Because you’re getting paid based on income, right? On your income. And the income are reliant on the tax brackets as they’re set. But what we’re trying to do is try to dodge this kind of marginal tax bracket of 25, 30 percent or beyond. Dodge it now, put it in the account before it gets taxed.
So, for instance, the individual that took the money, they had one hundred dollars. They only came back with 70. You got all one hundred dollars in the account growing for you. And that growth is also tax free. This is a big deal. So instead of seventy dollars growing over the intervening 20 or 30 years, the one hundred dollars is growing over the twenty, thirty, and each additional contribution as well.
And so then what happens when you draw it out now that you’re not working. And let’s say you bought one hundred dollars of this of this low cost, broad-based index fund over the past 20 or 30 years due to the process of capital gains. It’s doubled or tripled or quadrupled in price. All of that growth was was tax free. And it didn’t. It didn’t. It didn’t cost you anything because it’s in this protection, the sheltered bucket. The government does not tax you on the growth and now you’re pulling it out.
So now when your accessing it you get to decide how much income you bring home based on your marginal tax brack. You’re not talking about marginal tax brackets. and outside of your 401K when you are talking about taxable investment now you are looking at capital gains tax brackets. And Capital Gains are incredibly flexible, I was looking at at a couple that’s married filing joint, the long term capital tax rate is zero percent right now on someone that makes zero to eighty thousand. So if you have no income, that means up to eighty thousand dollars a year in capital gains. You can, you know, pull out. Right. And without paying any tax on it. That is incredibly appealing.
Now, we don’t know 30 or 40 years from now if it will be exactly as it is now. I just don’t have that I can’t predict the future on that, but it’s probably likely that capital gains tax rates will always be more advantaged than the income tax rate. That’s way it’s been for a very long period of time. And I would suspect that even in the future, capital gains will be will be taxed in a more favorable way than in W2 income.
So this means that you have a real incentive to get to the point where you can control your tax rate. And as soon as your marginal tax rate is moving up past 12 percent and you’re in that 25, 30 percent beyond, we want to see what we can do to delay the tax burden on that till we’re at a point where we can control our income and control our income bracket. Keep in mind that at this particular point time, since you’re able to control your income, you might decide to pay off your mortgage, you might decide to pay off your car.
So while a lot of what it takes for you to live your life right now involves you, you know, to pay your mortgage, be able to make your car payment, etc.. The future doesn’t necessarily you’ll have removed a lot of those costs. And, you know, eighty thousand dollars goes a very long way when you have no mortgage, no debt, no payments. I mean, you can make that work.
And that’s why I’m going to hedge my bets and I’m going to try to defer those taxes, get it into a tax-advantaged vehicle. Like I mean, just to list them off for you. The 401k, the TSP and traditional IRA, if I’m eligible. You know, just take advantage of any tax-deferred vehicle you can and other one, 457. If you don’t have access to these and your only option is a 403b. Maybe. Probably likely. You know, that’s a separate conversation, but get take advantage of those tax-deferred vehicles when and where they’re available. And in the context of you, that’s just the vehicle, right? It goes back to that initial conversation. That’s the vehicle. Now, what are you invested in? And now we’re looking for low cost, broad-based index funds at your provider of choice.
Jared’s 401k Advice
[MK] And that tees us up really nicely for the next item from our mailbag that we got in. So everybody listening is probably like, yes, I want to contribute to my 401k now. Let me rush over to my H.R. department and fill everything out. So Jared wrote in with a reminder about these contributions.
He says, I was a bit overzealous in my recent attempts to max out my 401K setting my contribution rate at 40 percent. I was anxious to get that checked off for 2020 so that I would have more disposable income to deposit in my traditional investment account in reviewing the employer match on my paystub. I recognize that the match amount was not 40 cents on the dollar up to 6 percent of my salary as advertised in our benefits package. I followed up with our H.R. department to better understand how the match is calculated, fearing that I might be jeopardizing the company match by maxing out early.
Turns out that the company match is evenly distributed on each paycheck through the course of the year. i.e. if I stop contributing because I’ve maxed out my contribution early, the match stops. What I thought was a good thing, maxing out by May would actually cost me thousands of dollars in company match. If only I had known this last year. So anyway, I bumped my aggressive contribution rate down so it will last throughout the year and I can maximize the company match. I’m not sure if all companies follow this pattern, but it’s worth looking into for anyone trying to max out early. Keep up the good fight.
[Jonathan] Yeah. So this is actually fascinating and I appreciate his zeal. I would be there as well. In fact, Brad, you just recently talked about how January 1st hit, you get that HSA maxed out. Right. But he’s rightly pointing out there’s some nuance here. Like if you’re a company, we just don’t know because company’s policies are different. Millionaire Educator was famous, infamous for always going into his H.R. department and trying to get at the beginning of the year try to get paychecks that would be like five cents or less. The implication being everything else just went to maxing out that in his case, I think it was a 403b and a 457.
But you want to have this conversation and you want to find out what your employer, how they’re actually applying that match. So if in this case, you were to front-load it, they’re expecting they’re gonna be giving you 4 percent, which over a period of fifty-two paychecks or twenty-six paychecks depending on your bi-weekly or monthly or whatever, you know, over that year they’re going to match you up to 4 percent, giving you that full amount at the end of the year.
If you front load and you’re only contributing for the first couple paychecks. And so as a result of that there’s nothing being contributed the remainder of those paychecks. Then he’s saying he’s going to be out that money. He’s going to miss thousands of dollars in contributions. So as much as you know, this kind of goes to the point of like dollar cost averaging. And you have the market at or near the top 90 percent of the time, then we want to be in the market as quickly as possible so that as the market continues to stay at or near the top, you know, always going higher. We want to make sure that money can get invested as much as possible, but we don’t want to do that at the cost of the company match, which is a guaranteed return.
So very good advice and timely advice for those of us to consider ourselves overzealous.
[Brad] Yeah, in this case, Jared would have cost himself thousands of dollars. So just like anything, do the research, ask the question. If you are one of those people who is in a case where you’re going to max out before the year end. And certainly if it’s earlier in the year, just go into your H.R. department and just ask the question. It’ll take you five or 10 minutes and potentially save yourself thousands of dollars.
[Jonathan] But it is kind of cool when your H.R. comes to you with a question because they want to know if it’s OK to give you a paycheck for four cents.
[MK] You know, what’s funny is I actually had some of those conversations last year when I knew I would be leaving my corporate job. So I was trying to max out the 401k, max out the HSA before I left. And well, my favorite person at the company who handled our payroll, she was just a very sweet, came over and she was like, do you have anything to tell me? Like, assuming that I was pregnant and trying to front load all my costs for the year and I was like, no, I’ve nothing to tell you because the actual news is I’m leaving, but I can’t tell anybody yet.
[Jonathan] So I got to keep a secret. That’s awesome.
ChooseFI Local Groups
[Brad] All right. M.K., so we have some interesting news in the ChooseFI local group world. I hear.
[MK] Yes, we have several new groups and it looks like it’s going to be a very busy February with a lot of events going on.
So on February 19th, the ChooseFI New Hampshire group set up their first meeting ever in Exeter. They hope that they can make this a monthly event if you’re in New Hampshire check out that event.
On February 23rd, ChooseFI Santa Cruz is hosting a potluck and a discussion about the intersection of environmentalism and frugality, where they work together, where they conflict and our experiences and strategies around living both paths. It sounds like a very well thought out, very well planned event. So check that out if you’re interested in your in the Santa Cruz area.
[Brad] That is so cool. Yeah, this seems like the year of the ChooseFI local group. From what I’ve seen in the Facebook groups, Jonathan, I we’re both members of every single local group. I have seen more events scheduled in the first five weeks of 2020 than I can recollect in maybe all of last year. It’s amazing.
I mean, these groups are really coming together and it’s just marvelous to see this is community and it’s so wonderful. I mean, I’ve seen our Richmond local group. We now have Emily taking charge as the admin. And I think she just posted something like six to 10 new events just for the next handful of months. And people are getting together and having little potlucks on their own. They’re just, they’re making friends. Right. This is community.
So if you’re out there, you’re a member of a local group and let’s just say your local group hasn’t had an event in awhile. Set one up. You don’t have to wait for somebody else. There’s no they. Right. They is you, set up an event, have people over to your house meet up at a local park. Right. That is the beautiful thing here. There are almost 300 of these ChooseFI local groups across the world. I would love to see a month where all of them have an event, right? Just have one event. Meet somebody new, do something simple. And yeah, I mean, I’m just so happy. I mean, to me, this is ChooseFI. These local groups, there they are everything. And it’s just so, so wonderful to see them come together like this.
[Jonathan] And, you know, and Brad, I know one of the things that we’ve talked about is we are just trying to figure out how to do our best to support these local groups. What does that look like? How can we promote them? How can we provide resources to make them more effective at whatever their goals are, whether it be to form community, whether it be to be ambassadors to their community, to spread financial literacy, whether it be to partner with nonprofit organizations like Junior Achievement, whether it be to hold a FI 101, you know, session for their local group members have really this is the gateway to financial literacy.
And we have ambassadors all across the country that want to be there, either be an instructor or literally want to use this as an opportunity to take this class with a friend, spouse, partner or someone that they know would benefit from this. What does it look like? It’s not all connected yet. Right. I mean, I think we kind of see vision and we’re creating the tools and the local groups are doing the events, creating the community. And we’re gonna get these connected and we’re going to just keep making this better and hopefully continuing to provide the resources that this community can use as we do our best to spread this idea of financial literacy around the world and see the community that comes out of that.
Just a quick, I want to make a quick note. If you’re hearing this, you’re not yet connected to your local group or if you just want to find out if there is a local group in your area. Easiest way to do that. Just go to ChooseFI.com/local. Find a group near you.
[Jonathan] Now, unfortunately, that is gonna bring this episode to a close now. As you know, we’d like to finish every episode by doing a drawing for a copy of a book that we found useful. We’re doing our book ChooseFI: Your Blueprint to Financial Independence can be found anywhere books are sold. Or you for in this season of life, you’re on a frugal bandwagon. You want to win a copy. All you need to do just go to ChooseFI.com/itunes. Follow the instructions there. Leave us a short written review on either iTunes or Stitcher or your platform and send us an email to feedback@ chooseFI.com letting us know that you left a review on what screen name we left it under. We give away one book for every five written reviews that we get and we announce a winner on the Friday roundup. Okay. How many winners do we have today?
[MK] Well, guys, we have one winner today, and this review comes from Lauren. She says, I rarely write reviews, but these guys deserve a shout out. We found ChooseFI about a year ago and have loved it as a way to dive into the Financial Independence movement. We were looking for something more in the personal finance arena to help us grow, and we found it here. I’m a family doctor and I found myself sharing ChooseFI with some of my patients. Sometimes the show in general for a young person just starting out or someone making a big transition. Sometimes a specific episode that has something in common with my patient. Much the way I recommend a few favorite books or websites, wide breadth of topics, deep dives when necessary. I love the generosity with which they seek out and share information. Thank you for helping us all live better, happier lives.
[Jonathan] Thank you. The fire is spreading. My friends will see you next time as we continue to go down the road less traveled.