Since most employers today no longer provide defined benefit pension plans for their employees, the burden of retirement saving has shifted to the employee. Not surprisingly, saving for retirement is a pretty low priority for the many Americans who are focused on how they are going to pay this month’s bills.
I know that New Year’s Resolutions are often lampooned as pointless and misguided, but I, for one, love the idea that people can change and take steps to improve their life. To me, a resolution is the wonderful intersection of optimism to motivate you and realism to recognize that it takes hard work to accomplish worthwhile goals.
Fidelity Investments has undertaken a New Year Financial Resolutions Study for seven years and found that individuals who started 2015 with a financial resolution feel more optimistic, are more debt-free, and feel more financially secure than individuals who did not make a resolution. The key to succeeding with a resolution, in my experience, is having the ability to translate a desire into a clear objective, determining how to accomplish that goal, and then having the discipline to stick to your plan.
In other words, a New Year’s Resolution is just a small scale financial plan. Here are three categories of financial resolutions and how to best achieve those objectives:
1) That one thing you’ve been putting off. A lot of times, people have something they know they should be doing, but haven’t started. Maybe they don’t know where to begin, are overwhelmed by the number of decisions they will have to make, or maybe there just never is enough time.
Here are some classic examples of financial needs that many organized, otherwise responsible people have not “gotten around to”:
- Starting a college fund for children or grandchildren.
- Securing a term life insurance policy to protect your spouse or loved ones.
- Establishing your will and estate planning documents.
If these are on your “keeps me up at night” list, give me a call and we will accomplish these in no time. You haven’t done this before, but we do this all the time. Start now and you could have these New Year’s Resolutions wrapped up before the end of January!
2) Save more. Many families worry they are not saving as much as they should. For some, it may be setting up an emergency fund; for others it may be saving for retirement, college, or other long-term goals.
Whatever your investment need, you are more likely to be successful when you put your saving on auto-pilot with electronic monthly contributions. When you pay yourself first every month, most people find they don’t even miss the money. Spending often takes up whatever amount we don’t save; if we recognize this, then we can also understand that it is usually very easy to adjust our discretionary expenses when our saving is automatic.
While the 401(k) is the classic example of automatic investing, we can just as easily use the same approach for an IRA, taxable joint account, 529 college savings plan, or any other type of investment vehicle. Saving more doesn’t happen by accident. You can’t wait until next December to do something if you expect to be a good saver in 2016.
3) Reduce Debt. If you are looking to reduce your spending to get out of debt, you can follow the same advice of making automatic monthly payments. Focus on paying down your highest interest rates loans first.
If you’re not sure where your money goes every month, your first step is to get better organized. Technology can be a big help; consider an app like Mint or Quicken to track your spending. Increasing your self-awareness is an essential step towards changing behavior.
A financial planner can help you with all of your financial questions and goals. Besides bringing expertise, training, and real world experience, a planner can also offer two of the most important elements of success: a concrete plan and accountability to stay on course.
If you are thinking about including financial goals in your New Year’s Resolutions, don’t go it alone, give me a call! I’m here to help.
The average car on the road today is 11.5 years old today, according to USA Today. Today’s cars are more dependable and long-lasting than ever and yet for many consumers, transportation remains their second largest expense after their home.
Last November, I purchased a used car, and not the typical 2-3 year old gently used vehicle, but a 2002 Toyota 4Runner with 179,097 miles. I wanted a larger vehicle to transport my three big dogs and wanted something I wouldn’t worry about getting muddy or scratched.
Admittedly, I have been leery of older cars. What if they break down? The last thing anyone wants is to have unexpected large expenses trying to keep a dying vehicle on the road. And I especially do not want to have an unreliable or unsafe vehicle when it is 102 degrees in July or 20 degrees in January.
Well, I’ve lived with my old car for a year now and will give you a full report, including a breakdown of all my costs. I drove the car almost every day and put just over 11,000 miles on this year (the photo is my current odometer reading: 190,182 miles). During that time, it has been 100% reliable (knock on wood…). The car has always started and worked perfectly. I have had zero breakdowns and no unplanned maintenance.
As a student of behavioral finance, I think people’s car buying choices are interesting to study. Most of us buy what we want, but then create a rationalization that sounds good for why we “need” a new car. Oftentimes, it’s really about projecting an image of success or trying to fit in with others in the office, neighborhood, or group of friends.
Many people prefer a new car, under warranty, to avoid the unpleasantness of having to pay for car repairs. This is known as “loss aversion”, which means that the pain of a $500 loss is much more intense and memorable than the satisfaction of a $500 gain.
Getting a new car every three years may cost $400 or $500 a month regardless of whether you lease, finance, or pay cash. With an older car, your depreciation can be very small, and instead your main expense is typically maintenance. You may end up spending $800 twice a year in repairs and upkeep. That sounds terrible, but which costs more: $400 a month, or $800 twice a year?
Having a used car may leave you on the hook for unplanned repairs, but the chances are good that those repairs will be a small fraction of the ongoing cost of getting a new car every three years. It’s loss aversion that makes $1,600 a year in unplanned repairs feel much worse than the fact that you might save $400 a month ($4,800 a year) by not having a car payment.
I paid $4,500 for my Toyota, and had to pay $316.75 in sales tax and registration fees. My biggest expense for the year was for a set of four new tires, $744.84. I did all the work on the car myself, including three oil changes, replacing the rusty radiator, hoses, and thermostat. I changed the fluids, including brake, transmission, power steering, and differential oil. I installed a new air filter, PCV Valve, and wipers, and cleaned the intake twice. In total, I spent $521.23 on maintenance, which was quite low since I did the work myself.
According to Kelly Blue Book, the current value of my vehicle is $4,044, so my estimated depreciation for the year was $456. Including depreciation, my cost for the year was $2038, which works out to 18.4 cents per mile (not including fuel). My insurance cost was much lower with this car; I kept the same high level of liability coverage as my other vehicles, but dropped collision. The annual insurance premium was $510.40, less than half the cost of our other vehicles.
What are the takeaways from this experience? A couple of thoughts:
- A well-maintained vehicle can certainly last 150,000 miles or more. Your best choice is always to keep your current vehicle for as long as possible and remember that even if you spend a couple of thousand on repairs per year, that is a small amount compared to the costs of depreciation associated with the first 5 years of a new cars’ life.
- Buying a used car is always going to be a bit of a gamble. Do your homework and choose a vehicle known for its dependability and ease of repair. Keep up with routine maintenance, using the manufacturer’s recommended schedule. Get to know a trustworthy independent mechanic.
- I know that keeping a car for 10 years is a great idea, but for me, I just get bored with a vehicle after a couple of years and want something different. Knowing this preference, I can buy a used car every couple of years and not have the staggering depreciation costs of new vehicles.
- It’s okay to spend money on cars, but if you think that retirement, paying down debt, saving for college, or growing your net worth are more important, than you need to make sure to prioritize those goals ahead of new cars. Every financial planner has met lots of people who have a new Mercedes but who “can’t afford” to contribute $5,000 a year into an IRA. Make sure your spending reflects your values and goals, and is not based on what you want others to think.
Gen Y is bringing frugality back in style. As a financial planner, I’m delighted to find frugality is cool now. I’ve read their blogs (where else would they write?) with fascination and appreciation for their candor. I’m calling this the New Frugality, and you’ve probably heard or read about some of these ideas, including the Tiny House, where people live in a home often smaller than 200 square feet. Others are embracing Minimalist Wardrobes, creating a personal, seasonal clothing uniform (think Steve Jobs with his jeans and black mock turtleneck). This past week, there was an article in Forbes about the Frugalwoods, an anonymous Boston couple who is saving 71% of their income so that they can retire at age 33 and move to a Vermont homestead with their rescue Greyhound.
In these blogs, the authors are never afraid to share their personal stories, from big-picture motivations and life philosophies, to the smallest minutiae of their daily decisions. Along the way, we invariably learn of their challenges, missteps, and triumphs. The blogs are part diary, part instruction manual, and part entertainment for their friends and fans. Even with different goals and approaches, there are common beliefs.
- The New Frugality believes that less is more, and does not buy into the modern American idea that “buying more stuff” can make you happy. They have a maturity (which takes some people 70 years to develop) that recognizes that happiness comes from rewarding experiences, positive relationships, and a work/life balance that includes a higher purpose.
- They want off the financial treadmill. Some had large student loans or crippling credit card debt before having an epiphany about becoming debt-free. Others found their corporate careers unsatisfying and were brave enough to recognize that spending the next 40 years in a job they hate isn’t worth it just to be able to afford a big house and a fancy car.
- While others may view their frugality as a sacrifice, they often find that simplifying their lives and eliminating clutter brings a clarity to their sense of what is truly important to them.
The New Frugality is about seeking the quality of life you want today, rather than believing you should wait until some future date, i.e. retirement, before you can really do what you want. It’s an implicit rejection of the old notion of working 50 hours a week until age 65, then never working again.
[In case you are wondering, I contrast the New Frugality with previous beliefs about frugality which were created by those who lived through The Great Depression and who raised their children in a different, frugal manner. While both the old and new approaches want to stretch each dollar, the old frugality was characterized by self-reliance, never throwing away anything you might need in the future, risk avoidance, and mistrust of financial systems. Some of those traits were largely fear-based, which does not resonate with the abundance mentality I embrace and believe is required to be a patient and successful investor.]
Does frugality make you happy? I think the most literal answer is no. By that, I mean that if you are unhappy, spending less won’t make you happy. If you really enjoy going to Starbucks every morning, cutting out that $5/day habit isn’t automatically going to improve your satisfaction, even if it enables you to save $1,825 a year. Frugality works for these bloggers because they were willing to embrace changes to their habits even though society was telling them to spend more money instead. There’s no doubt that frugality is financially beneficial, but the sources of happiness include a lot more than just your financial situation.
Reading their blogs can help you appreciate your own spending more as well as to feel good, and not alone, when you do choose a frugal approach. We are continually bombarded with advertising that suggests we’d be happier, cooler, and more attractive if we had the right car, clothes, or beauty products. We’re told that our current life would be better if we had a bigger home, nicer furniture, or luxury vacations. Of course that’s not true. We know that spending to increase our satisfaction is at best a fleeting pleasure which can leave consumers addicted to living beyond their means. Unfortunately, there are so few voices pushing back on the advertisers’ message to consume.
Even if you don’t want to live in a tiny house, reduce your wardrobe to a few pieces, or bike to work, you can still take frugal steps to ensure you are working towards true financial independence, which we define as working because you want to and not because you have to. Here are six lessons to take away from the New Frugality:
- Beware of lifestyle creep. Many of us were very happy in college, even though we may have had a rickety car, tiny apartment, and slept on a futon. It doesn’t take long after graduation to discover the urge to “keep up the Joneses”, as friends buy big houses and fancy cars. How can they afford it? Oftentimes, they can’t and they’re up to their eyeballs in debt. They’re more concerned about their image than their net worth, and that’s not something to emulate! If you increase your living expenses every time your income goes up, you aren’t ever going to become wealthy.
- Save at least 15% of your income. Set financial goals, including a “finish line”. If you are highly motivated (or just impatient, like me), you will realize that the more you save, the sooner you will reach your finish line. Saving then is not a sacrifice, but the fastest, most direct way to achieve financial independence. When your goals are more important to you than a new (fill in the blank), your spending decisions become much easier.
- Avoid impulse buys and emotional shopping, that is shopping to distract you from sadness, frustration, or boredom. Never buy on credit; if you don’t have cash to pay for something, it’s not worth going into debt. Be conscious and intentional about your spending behavior. Do your choices reflect your goals and beliefs?
- Buy used. There is a growing market for used items, often selling at a small fraction of the cost of new items. This is the Craigslist economy, which is growing around the country. You can often buy what you need without paying full retail prices.
- Savor success. There is a great deal of intrinsic satisfaction in becoming financially independent. Even taking the initial steps towards creating a positive cash flow are great confidence boosters because people feel empowered when they take control of their financial life. As every financial planner will tell you, the more you need to spend, the larger the nest egg required to be able to fund your future needs. Therefore, when you reduce your spending, you not only can save more, but you also reduce the size of the nest egg you will need to replace your income.
- Reduce stress. While money is not the source of true happiness, there is no doubt that being broke, in debt, or just knowing you are not setting enough aside for the future, can be a significant source of personal anxiety and marital friction.
As a bonus, you will find great common sense financial planning tips on these blogs. What are the Frugalwoods doing with the 71% of their income the save? They maximize their 401(k) contributions and invest the rest in the market. They write: We’ve done well because we invest in boring index funds and we don’t sell when the market is down. That’s a great recipe for success!
Reading about the New Frugality is entertaining because many authors are willing to take their frugal habits to quite an extreme. Even if we don’t adopt their spartan lifestyle, they can remind us that we don’t have to spend money to be happy.
When I tell people I’m a financial planner, I often get a response like “I wish I needed that service”. I know a lot of people live from paycheck to paycheck, including people who have graduate degrees and good jobs. It’s tough to have a conversation about something as far away as retirement when someone is worried about how they’re going to pay their bills two months from now.
No matter where you are today, it is not a hopeless situation; anyone can change their position for the better. It requires a plan, the willingness to make a couple of changes, and the determination to stick with it. If you’d like to be richer in one year from now, here’s how to get started.
1) Get organized. Do you know how much you owe on credit cards or what the interest rate is? How much money do you need each month to cover your bills? How much should be left over to save or invest? Establish a filing system, or use a tool like Mint.com or Quicken so you know how much you are spending and where. Like a lot of things in life, preparation is half the battle when it comes to personal finance. It can feel a bit daunting at first to take an in depth look at your finances, but ultimately it’s empowering because you will discover for yourself what you need to do.
2) Start tracking your net worth. There are two parts of your net worth: your assets (home, savings, investments, 401(k), etc) and your liabilities (mortgage, credit cards, other debt). Your assets minus your liabilities equals your net worth. If you take 30-45 minutes to calculate your net worth every month, it will change how you think. Just like starting a food journal or an exercise diary, tracking your net worth will make you mindful of your behavior. When you create a higher level of self-awareness of your actions, you will automatically start to change your habits for the better. And of course, if you don’t track it, how will you know if you are richer in one year?
3) Plan your spending. Most of us have a fixed salary where our ability to save depends on spending less than we make. People assume that if they made more money, it would be easy to save more. Unfortunately, what I have actually found as a financial advisor is that families who make $100,000 are just as likely to be broke as families who make $75,000. They may have a bigger house or a fancier car, but they’re no richer. If we want to save more, we have to learn to spend less.
The key to spending less is to find a system or process that works for you. For some people, creating a detailed and strict budget is key. For others, it may work best to become a cash consumer, where you leave the credit cards at home and only spend a set amount of cash each week. It can be helpful to comparison shop all your recurring bills and look to switch providers to save money. (For example, home/auto insurance, cell phones, gym membership, electric provider, etc.) Lastly, people are saving money by dropping their landlines, or dropping cable for Netflix.
4) Put your saving on autopilot. Money that you don’t see can’t be spent. You’re more likely to be a successful saver when you establish automatic contributions, versus waiting until the end of the year and hoping that something will be left over to invest. If your company offers a 401(k) match, that’s always your best place to start. If a 401(k) is not available, consider a Roth or Traditional IRA. If you don’t have an emergency fund, set up a savings account separate from your checking account, so you can’t easily access those funds. Even if you can only save $100 or $200 a month for now, that’s okay, because you’re creating a valuable habit. When you get a raise or receive a bonus, try to increase your automatic contributions by the amount of your raise.
5) Don’t go it alone. People are more successful when they have help, good advice, and accountability from another person. That may mean hiring a Certified Financial Planner, joining a Dave Ramsey Financial Peace class at a local church, or finding a knowledgeable friend who can lend an ear. If you’re looking for help with debt and improving your credit, contact the National Foundation for Credit Counseling at www.nfcc.org or by phone at 800-388-2227.
If you make these five changes today, you will be richer a year from now. Habits are important. For most people, wealth isn’t accumulated suddenly or through significant events, but by years of getting the small decisions right. Build a strong financial foundation, then you will find that a financial advisor can help you take the next steps to creating the financial life of your dreams.
“Don’t be penny wise and pound foolish.”
This old nugget of wisdom remains relevant today with many people feeling frustrated that even with a decent income, it seems so difficult to save as much as we’d like for retirement and our other financial goals. Rather than worrying about the pennies, I think investors who want to increase their saving are best served by focusing on their two biggest expenses: their home and cars.
Although not a great investment, a home is generally an appreciating asset and offers some valuable tax deductions. It is possible to have too much home and be house rich and cash poor, but our focus is better first directed on car expenses. I love cars, as do most Americans. A car represents freedom, and as a kid, I couldn’t wait to learn to drive. I took my drivers permit test right on the day of my 16th birthday. We view our cars as a representation of our self, our status, and our importance. Yes, even Financial Advisors are guilty of this irrational vanity! (Or is it insecurity?)
Unfortunately, a car is a depreciating asset and often our biggest expense outside of our home. New car prices seem to have outpaced wage growth, and everyone always wants the latest and greatest. We have to set priorities for how we use our income, and any money we spend on a car is gone. You won’t get it back, it’s just flushed away. That’s money we can’t invest and can’t use to create our future independence and income. If you want to have more of your money working for you, it pays to be smart about your cars. Here are five ways to keep your automotive expenses down.
1) Keep what you have. Cars greatest depreciation is in their first 3-5 years, so if you can keep your car longer, your annual costs will be lower. The more frequently you replace your cars, the more expensive it will be. That’s the number one thing you can do: keep your vehicles 7-12 years. The more often you sell one car and buy another, the higher your costs over time.
2) Don’t fear the occasional repair. Today’s cars are more dependable and long-lasting than ever. Psychologically, people hate repairs, since they seem to always occur at the most inopportune moments. Many people would rather spend $500 a month on a new car payment rather than risk having $1,000 to $2,000 a year in maintenance and unplanned repairs. Does it make sense to spend $6,000 a year to avoid spending $2,000? Probably not, but this is what you are doing if you think that you must sell a car as soon as it is past its warranty.
It’s true, it feels much worse to spend $2,000 on an unplanned repair than to spend the same amount in scheduled car payments. In behavioral finance, this is called “prospect theory”, where people feel the impact of a loss much more severely than the benefit of an equivalent gain. Unfortunately, this can lead to less than ideal decisions, such as buying a $40,000 car because we’re upset over a $400 repair.
If a car is in relatively good shape, it will most likely be cheaper to keep a car with 100,000 miles on the road, rather than replacing it with a new car.
3) Pay cash for your cars. Most people don’t want to spend $60,000 on a new car, even though we all want that $60,000 car. I’d like to first point out the opportunity cost here. At a hypothetical 8% rate of return, spending $60,000 today on a car means not having $120,000 in 9 years, $240,00 in 18 years, or $480,000 in 27 years. That’s a steep price for a car. Which would you rather have, a new car today or potentially an additional $480,000 at retirement?
The strategy of paying cash for cars isn’t just about saving on interest payments; it’s about changing your behavior. Paying cash will force you to spend less, to look at used cars, and to keep your current car longer. Too often, I hear people brag that they got a new car and kept their payment the same. So what! Your current payment was going to end – all you’ve done is keep yourself in debt for another 5 or more years.
If you currently have a car payment, once your payments end, set aside that monthly amount in a savings account for your next car. Paying cash forces you to delay buying a new car. Otherwise, it’s very easy to take a loan for a new vehicle and then rationalize why you “needed” a new car.
4) Save money on maintenance. If you’re handy with tools, you can save a lot of money by doing some routine maintenance yourself. My dealership wanted $499 for a 30,000 mile service consisting of an oil change, tire rotation, brake fluid change, and replacement of two air filters. I did the work myself and spent less than $70 on materials. Oil changes are cheap, so you can’t save much there, but you can save a lot if you learn to replace your brakes.
Don’t try to save money by skipping preventative maintenance. Make sure you change all fluids on the factory recommended schedule. Even if you do some work yourself, I’d also suggest developing a good relationship with an independent mechanic who you trust to give you honest advice.
5) Know when to buy new, buy used, or lease. The price of used cars has skyrocketed in recent years. It used to be that a 1-year old car had lost 20% or more of its value. Today, that can be under 10% for some popular makes and models. This increased residual value has changed some of the old rules about car buying. A gently used 2-3 year old car is, in many cases, not the bargain that it was 10 years ago. In those situations where resale value is very high, you might actually consider buying new. This will improve your future resale value, keep you under warranty longer, and possibly offer better terms on any financing. If you’re planning to keep the car for a long time (7-12 years), starting with a new car can be a good decision.
Buying used cars used to be an easy way to save 30% or more. There are still some good deals on used cars, but consider dependability, any remaining factory warranty, and the cost of maintenance on used vehicles. If you get bored with vehicles after a couple of years, used cars will have less depreciation than buying new.
Leasing is more expensive than keeping your cars for as long as I’d suggest. However, it is still a good alternative to buying a new car every three years, provided you drive fewer miles than stipulated in your lease agreement (often 10,000 or 12,000 miles per year). For models with high residual values, lease rates have stayed low.
Manage your car depreciation like you would any other liability. At the end of the day, a car is just a way to get from point A to point B. It doesn’t define us, who we are, or what our value is to our family or society. If you have other priorities like retiring early, buying a vacation home, or making your first million (or your second or third million), recognize when your car buying is not helping you get closer to achieving your more important goals.
A study by the Putnam Institute, “Defined Contribution Plans: Missing the forest for the trees?” contends that while a number of variables, such as fund selection, asset allocation, portfolio rebalancing, and deferral rates all contribute to a defined contribution plan’s effectiveness — or lack thereof — it is deferral rates that should be placed near the top of the hierarchy when considering ways to boost retirement saving success.1
As part of its analysis, the research team created a hypothetical scenario in which an individual’s contribution rate increased from 3% of income to 4%, 6%, and 8%. After 29 years, the final balance jumped from $138,000, to $181,000, $272,000, and $334,000, respectively.
Even with a just a 1% increase — to a 4% deferral rate — the participant’s final accumulation would have been 30% greater than it would have been using a fund selection strategy defined as the “Crystal Ball” strategy, in which the plan sponsor uses a predefined formula to predict which funds may potentially perform well for the next three-year period. Further, the 1% boost in income deferral would have had a wealth accumulation effect nearly 100% larger than a growth asset allocation strategy, and 2,000% greater than rebalancing. Of course these results are hypothetical and past performance does not guarantee future results.
One key takeaway of the study was for plan sponsors to find ways to communicate the benefits of higher deferral rates to employees, and to help them find ways to do so.
Retirement Savings Tips
The Employee Benefit Research Institute reported in 2014 that 44% of American workers have tried to figure out how much money they will need to accumulate for retirement, and one-third admit they are not doing a good job in their financial planning for retirement.2 Are you? If so, these strategies may help you to better identify and pursue your retirement savings goals:
Double-check your assumptions. When do you plan to retire? How much money will you need each year? Where and when do you plan to get your retirement income? Are your investment expectations in line with the performance potential of the investments you own?
Use a proper “calculator.” The best way to calculate your goal is by using one of the many interactive worksheets now available free of charge online and in print. Each type features questions about your financial situation as well as blank spaces for you to provide answers. But remember, your ultimate goal is to save as much money as possible for retirement regardless of what any calculator might suggest.
Contribute more. At the very least, try to contribute enough to receive the full amount of any employer’s matching contribution. It’s also a good idea to increase contributions annually, such as after a pay raise.
Retirement will likely be one of the biggest expenses in your life, so it’s important to maintain an accurate cost estimate and financial plan. Make it a priority to calculate your savings goal at least once a year.
Today’s blog content is provided courtesy of the Financial Planning Association.
1Putnam Institute, Defined Contribution Plans: Missing the forest for the trees?, May 2014.
2Ruth Helman, Nevin Adams, Craig Copeland, and Jack VanDerhei. “The 2014 Retirement Confidence Survey: Confidence Rebounds–for Those With Retirement Plans,” EBRI Issue Brief, no. 397, March 2014.
Because of the possibility of human or mechanical error by Wealth Management Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall Wealth Management Systems Inc. be liable for any indirect, special or consequential damages in connection with subscriber’s or others’ use of the content.
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Answer: save $5,466 a month and earn 8%.
I thought about ending the article there, because that’s all you actually need to do. Investing is simple, but it isn’t easy. No one likes the answer above, even though it really is that simple. When confronted with a difficult task, our brains are wired to look for an easier way, a shortcut. Many investors waste a vast amount of time and energy trying to improve their return by timing the market, buying last year’s hot fund, or day-trading stocks.
Unfortunately, these attempts at finding a shortcut don’t work. It’s like someone who wants to run a marathon but not train for it. There isn’t a shortcut, you just have to do the right things, stick to the training schedule, and put in the miles. You have to earn it. Yet there are entire magazines, TV networks, and firms who make their living from telling people that the shortcut is to trade frequently, and that beating the market is the sure path to prosperity.
The truth that no one wants to hear is that investors would be more successful in achieving their financial goals if they instead focused on how much they save. Let’s step back and consider what we actually can control when it comes to our investment portfolios:
- how much we save and invest
- our asset allocation and diversification
- investment expenses
- tax efficiency, which can reduce (although not eliminate) taxes
We cannot control what the market will do this month or year, so ultimately we have to accept the ups and downs of each market cycle. We have many studies which consistently show that the majority of active fund managers under perform their benchmarks over time. We also have compelling evidence that the average investor significantly lags the indices due to poor decisions and fund selection.
Few people are able to save $5,500 a month. It’s not easy, but that is the way to get to $1,000,000 in 10 years. For a family making $200,000 a year, this would require you to save one-third ($66,000) of your pre-tax income. Again, not easy, but possible. After all, there are many families who are able to “get by” on $134,000 (or much less), so it is certainly possible for a family with an income of $200,000 to save $66,000. While there are many families in Dallas who make this amount or more, saving is viewed by some negatively, as a sacrifice, rather than with pride and recognition that it is the key to accomplishing your financial goals.
If you did the math, saving $5,500 a month, or $66,000 a year for 10 years is asking you to save $660,000 over 10 years. So even at an 8% return, the market performance is not the main source of your accumulation. Your saving is the main driver of your accumulation.
However, in the next decade, after you have achieved your first million, things become much more interesting. Compounding is your new best friend. At $1 million, an 8% return means you’re up $80,000, and you’re now making more from the portfolio than you contribute annually. Continue to invest $5,466 a month for another 10 years at 8%, and you’re looking at a portfolio with over $3.2 million.
And that’s why I get very excited talking about saving with high-income professionals. If you can commit to that aggressive level of saving, your success will be inevitable. Is an assumed 8% return realistic? No one knows for 2015, but I think 8% is likely to be attainable for 10 years and almost a certainty over 20 years. 8% isn’t going to happen every year, but historically, it is possible to average that rate of return over time. In the long-run, the returns can take care of themselves when you stick with a sensible, diversified approach. The factor which needs more attention, and which you can control, is your savings rate.
For 2015, the IRS has announced that contribution limits will increase for a number of retirement plan types. For 401(k) and 403(b) plans, the annual contribution limit has been increased from $17,500 to $18,000. The catch-up amount for investors over age 50 has increased from $5,500 to $6,000, so the new effective limit for participants over 50 is now $24,000. Be sure to contact your HR department to increase your withholding in January, if you are able to afford the higher amount.
Traditional and Roth IRA contribution limits will remain at $5,500, or $6,500 if over age 50. SIMPLE IRA participants will see a bump from $12,000 to $12,500, and SEP IRA contribution limits are increased from $52,000 to $53,000 for 2015.
If you’re not sure where to start, here are my five recommendations, in order, for funding retirement accounts.
1) Choose the Traditional Plan
More and more employers offer Roth options in their 401(k) plans, but I believe the most investors are better off in the traditional, pre-tax plan. The only way the Roth is preferable is if your marginal tax rate is higher in retirement than it is today. The reality is that your income will probably be lower in retirement than when you are working. Even if your income remains the same 20 years from now, it is likely that tax-brackets will have shifted up for inflation and you may be in a lower tax rate. Lastly, there has been continued talk of tax simplification, which would reduce tax breaks and potentially lower marginal tax rates, which would also be negative for Roth holders. So, my advice is to take the tax break today and stick with the pre-tax, regular 401(k).
2) Maximize Employer Plan Contributions
Your first course of action will always be to maximize your contributions to your employer plan. Many individuals do this, but I’m surprised that with many couples, the lower paid spouse often does not. If you’re being taxed jointly, every dollar contributed reduces your taxes at your marginal rate. And don’t forget that since 2013, on income over $250,000, couples are subject to an additional 0.9% tax on Earned Income and an additional 3.8% on Investment Income to provide additional revenue to Medicare. Add the 3.8% Medicare Tax to the top rate of 39.6%, and you could be paying as much as 43.4% tax on your investment income. That’s a big incentive to maximize your pre-tax contributions as much as you can.
3) Traditional IRA, if deductible
If you maximize your employer contributions for 2015, and are able to do more, here is your next step: If your modified adjusted gross income is under $61,000 single ($98,000 married), then you can also contribute to a Traditional IRA and deduct your contribution. If your spouse is covered by an employer plan but you are not, the income limit is $183,000. This opportunity is frequently missed by couples, especially when one spouse does not work outside the home.
And of course, if neither spouse is covered by an employer retirement plan, both can contribute to a deductible Traditional IRA, without any income restrictions.
4) Roth IRA
If you make above the amounts in step 2, but under $116,000 single, or $183,000 joint, you are eligible to contribute to a Roth IRA. If your income is above these amounts, you would not be eligible to directly contribute to a Roth IRA. However, if either spouse does not have a Traditional IRA (including SEP or SIMPLE), he or she would be able to fund a “Back-Door Roth IRA”. This is done by contributing to a non-deductible IRA and then immediately converting to a Roth. Since there are no gains on the conversion, the event creates no tax.
5) Self Employment
If you have any 1099 income, are self-employed, or work as an independent contractor, you would also be able to contribute to a SEP IRA in addition to funding a 401(k). You can contribute to both accounts, subject to a combined limit of $53,000, if you have both W-2 and 1099 Income.
One option I’ve not seen discussed often is that someone who is self-employed could also fund a SEP and convert it to a Roth. If you don’t have any other Traditional IRAs, this could, in theory, be used to fund a Roth with up to $53,000 a year. The conversion would be a taxable event, but it would be cancelled out by the deduction for the SEP contribution.
There are quite a few variations and details in terms of eligibility for each family. Want to make sure you’re taking advantage of every opportunity you can? Give me a call to schedule your free planning meeting.
While some people view risk as synonymous with opportunity, the majority of us don’t enjoy the roller coaster ride of investing. Our natural proclivity for risk-avoidance can, unfortunately, become a deterrent in deciding how much we save. Without having specific goals, investors often default to a relatively low contribution rate to retirement accounts and other investment vehicles. They commit only how much they feel comfortable investing, rather than looking at how much they actually need to be saving in order to fund their retirement or other financial goals.
In the November issue of the Journal of Financial Planning, Professors Michael Finke and Terrence Martin published a study of 7616 people born between 1957 and 1965, looking at whether working with a financial planner produced improved outcomes for accumulated retirement wealth. Here are their conclusions:
Results indicate consistent evidence that a retirement planning strategy and the use of a financial planner can have a sizeable impact on retirement savings. Those who had calculated retirement needs and used a financial planner… generated more than 50% greater savings than those who estimated retirement needs on their own without a planner.
When I read the executive summary of their article, I wondered if perhaps the results reflected that higher income people were simply more likely to use a financial planner. However, the authors took this into consideration. They controlled for differences in household characteristics such as income, education, and home ownership… Even after controlling for socioeconomic status, households that used a financial planner and calculated retirement needs had significantly higher retirement wealth accumulation across all quantiles relative to households with no plan.
Interestingly, the authors noted that this result of 50% higher wealth was not due to investment performance. When they looked at individuals who used a financial advisor who was not doing a comprehensive plan (such as a stock broker), they noted that using a planner without estimating retirement needs had little impact on accumulation compared to having no retirement strategy at all.
And that’s why we put planning first at Good Life Wealth Management. Goals dictate actions. Only when we have a clear picture of what you want to accomplish will we will know if you are on track or behind schedule. We’re more willing to save when we are working towards a finish line, as opposed to worrying about what the market is going to do next. If you’re looking for a comprehensive advisor to bring clarity to your goals and to carry out your game plan, I hope you’ll give me a call.