The Basics of the Path to Financial Independence

In these posts I’ll attempt to lay out the core of whatI believe are the basics of the path to Financial Independence. Please share your feedback and suggestions if you have any, :)!

• Saving for the future
• Where to put the money you have leftover after expenses
• How to make your investment decisions

Saving for the Future

Where to put money after expenses

How to make investment decisions

How to make investment decisions

We covered this briefly in the previous section but, for the most part, the riskier your investment is the more returns you’ll earn from it over time. Risk cuts both ways. Meaning that, depending on the investment you are choosing, the value of your investment could drop precipitously or be completely wiped out (if you’ve chosen something very risky like a single stock).

 

You can balance out some of the risk of a given asset class by diversifying within it and, on an overall level, allocating your investments to a mix of asset classes. To decide how to allocate your investment money you’ll want to think through the following things:

 

• What level of risk are you comfortable with?
• Should you hold multiple portfolios?
• How can you use index funds to your advantage?
• How involved do you want to be with your investments on a regular basis?
• Should you try and time the market? 
• Who should I invest with?
• What options do you have available to you for employer controlled, non-taxable investments?
• Will you want to adjust your risk profile over time?

What level of risk are you comfortable with?

Generally, when it comes to investing money you’ll want to find the investment opportunity that matches your risk tolerances. Riskiness of your various money storage options are as follows (least risky to most risky):

 

• Cash holdings (checking account, actual cash on hand, etc)
• Bonds
• Stocks (also known as equities)
• Real estate
• Private company shares
• Speculative investments (crypto, shorts, futures trading, etc)

 

Another rule of thumb is that the more diversified your investment is, the less risky it becomes. So, even though stocks are generally riskier (and provide higher returns) than bonds, holding a stock index fund could be less risky (and provide a lower return) than an individual bond.

 

The generally accepted rule for the highest consistently returning mix of assets (in the financial independence community) is buy index funds and have 80% – 100% of your investments in equities and 0%-20% in bonds. This mix gives you a consistently high return (~7% in the US market) without too much variation on a medium to long term basis. Of course, you’ll see dips in valuations (ranging from the dip at the beginning of 2019 to the massive crash in 2008) but your investments will grow along with the overall economy and are tied to the actual value that companies are creating in the stock market.

 

Here’s some more reading on allocations:

 

https://www.financialsamurai.com/the-proper-asset-allocation-of-stocks-and-bonds-by-age/

https://www.reddit.com/r/financialindependence/comments/8vxacm/anyone_100_in_equities/

https://www.gocurrycracker.com/path-100-equities/ 

https://jlcollinsnh.com/2014/06/10/stocks-part-xxiii-selecting-your-asset-allocation/ 

 

Here’s a great tool to play around with to better understand how certain allocations can affect your chances at achieving financial independence:

 

http://www.cfiresim.com/faq.php | http://www.cfiresim.com/ 

Why does diversification matter?

Using a sample stock market with 6 stocks and which is worth $100,000 overall. 

• Stock A’s market cap (overall value on the stock exchange) is $20,000
• Stock B’s market cap = $10,000
• Stock C’s market cap = $15,000
• Stock D’s market cap = $40,000
• Stock E’s market cap = $5,000
• Stock F’s market cap = $20,000

 

If you were to buy $10 worth of stock A you would be fully exposed to that single stock. That heavy exposure cuts both ways. If Stock A’s value doubles then suddenly your investment is now worth 2x ($20) what it was worth before. However, if the company goes bankrupt (unlikely but possible) or suddenly drops 30% in value then your investment will shift in value by exactly the shift in the stock price.

 

Of course, you may not fully commit to a single stock. You’ll probably choose a set of stocks that you feel comfortable investing in. Perhaps that set of stocks is as many as 15 stocks. But how do you know which stocks you should buy? Are you a domain expert? Do you have a special understanding of how a stock should perform relative to all the other options available to you? Will your choice of stock(s) outperform the market as a whole?

 

At some point, it becomes unrealistic to expect to be able to follow a basket of stocks to the point where you can more accurately choose when to buy and sell better than the professionals who are attempting to do the very same thing (and not successfully in the long term – see the section on index funds below). Hence the benefits of diversification! 

 

You choose what kind of exposure you want to risk and buy into overall asset classes rather than specific stocks. In the case of equities, this means that when Stock A drops in value by 30% you have only a 6% in your overall portfolio (30% decrease x Stock A’s 20% share of the market).This also means that you benefit from increasing value in stocks that you would never have thought to buy or perhaps never heard of. This brings us into the topic of index funds (the best way to access overall asset classes efficiently and at low cost)!

Should you hold multiple portfolios?

Bear in mind that the bulk of this post pertains to investing for the long term. If you have a significant expense coming up in the near → medium term (less than 5 years) you should hold that portion of savings in a different (read less volatile) allocation mix. See When will you need the savings to be available for your goal? (https://docs.google.com/document/d/1tL2Y9PzffqLKGZUEGU4e90ye6u3l7rvTP3bQDDDDDFk/edit#heading=h.4k9k1b7e6bov) for the relevant reading in the Saving for the Future post.

 

Basically, depending on the time horizon that you’ll need the money for, you may want to have separate portfolios for your different needs. One for long term retirement (25 years out) where you’re allocated 90% to stocks and 10% to bonds, another for your housing fund (3 years out) where you’re 50% stocks and 50% bonds and another for short term, unexpected expenses (emergency fund, potentially 0 days out) where you’re entirely in liquid, non-volatile assets (so a high yield checking account). The sooner you need to access the money the less volatile you’ll want your chosen allocation mix to be.

How can you use index funds to your advantage?

There is a wealth of research that shows that the best (in this case, resulting in the highest possible consistent gains) approach to investing is to make use of index funds. Index funds allow you to access the entirety of the market that you’re buying an index fund for (US stock market, US bond market, international stock market, etc). 

 

Because index funds are simply buying into each company within that market at a rate that matches their share of the overall market the expense ratios for these funds are very low. As a result, you get diversified exposure that evolves as the market changes without having to attempt to buy miniscule portions of each share on your own. 

 

Another advantage of index funds is that the low fees allow you to capture the majority of the growth in your investments for yourself. Even if actively managed funds may occasionally outperform the market they get dragged down by their fees and underperform index funds in the long run (on average with 75%+ of mutual funds underperforming at the end of a 10 year period when compared to index funds). 

 

A simple explanation of an index fund would be as follows:

 

Continuing with our stock market example, the market is composed of 6 stocks and worth $100,000 overall. 

• Stock A’s market cap (overall value on the stock exchange) is $20,000
• Stock B’s market cap = $10,000
• Stock C’s market cap = $15,000
• Stock D’s market cap = $40,000
• Stock E’s market cap = $5,000
• Stock F’s market cap = $20,000

 

If you were to buy an $10 of an index fund that represented this overall stock market you would be putting your money into those companies at the following rates:

• $2 into A, $1 into B, $1.5 into C, $4 into D, $0.5 into E and $2 into F

 

That example is heavily simplified but you can look at something like VTSAX (Vanguard’s Index fund for the US Stock Market – https://investor.vanguard.com/mutual-funds/profile/vtsax ) and see that the top 10 companies represent 18.81% of their net funds. So, when you’re buying shares in that index fund, ~%19 of your money is going towards investments in those companies with the remaining portion being broken down amongst everything else that is listed on the US stock market.

 

Because of your easy access to this tool for investing across a broad range of assets at a low cost you can quickly arrange a portfolio that matches your allocation target and put more money into the market with minimal time spent on managing what you’re buying in particular. By managing your risk across asset classes rather than on a per stock basis, you avoid overexposure to any single stock and benefit from overall growth in value for that asset class. 

 

See Warren Buffets bet against hedge funds as an example (https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp)

Take a look at this paper from Vanguard explaining the advantages of index funds (https://personal.vanguard.com/pdf/ISGIDX.pdf) 

More reading on the differences between index funds and actively managed funds

(https://www.nerdwallet.com/blog/investing/index-funds-vs-mutual-funds-the-differences-that-matter-most-to-investors/ )

How involved do you want to be with your investments on a regular basis?

Some people like to set up their investments and then completely forget about them (one of the best approaches to investing as you won’t get emotional and sell things in a downturn). Others like to check frequently, see how things are going and make adjustments. Depending on what you’re comfortable with, you’ll want to find a cadence to check in on your investments that makes sense for you.

 

I would recommend setting up automatic withdrawals from your checking account and having those be invested according to your allocations on a schedule that works for you. I, for example, have automatic investing set up with Vanguard where I pull $1600 from my checking account every two weeks (a few days after payroll hits) and put $1200 into VSTAX (https://investor.vanguard.com/mutual-funds/profile/fees/vstax) and $400 into VTIAX (https://investor.vanguard.com/mutual-funds/profile/fees/vtiax) which roughly matches my allocations of 66% domestic equities and 33% international equities (I also put my Roth IRA contributions into VTIAX to balance out to ⅔ and ⅓ overall).

 

If you’re ok with checking in quarterly to see if your allocations need rebalancing you can just choose individual funds to make up the mix of investments that you’re looking to. When you rebalance, you’ll either sell funds and buy others to get back to your target allocation (e.g. 90% equities, 10% bonds) or change your contribution mix (e.g. ¾ stocks and ¼ bonds instead of 0.9 stocks and 0.1 bonds) until it returns to the mix that you’re aiming to keep in your portfolio. Here’s a great paper from Vanguard (https://www.vanguard.com/pdf/icrpr.pdf) on why rebalancing is important and best practices for it.

 

If you prefer not to have to think about your investments after you’ve initially set them up, you can choose a fund that contains your target mix and automatically rebalances for you. The expense ratios for these funds tend to be more expensive than their component parts but keeping you on track with your investments and preventing you from avoiding it due to fear of complexity can make it well worth it. VTTVX (https://investor.vanguard.com/mutual-funds/profile/VTTVX) is an example of this sort of fund it is composed of 37% global equities, 26% domestic bonds, 25% international equities (non-US only) and 11% international bonds with an expense ratio of 0.13% (pretty good rate for a fund like this). This fund is meant for people who want to retire in 2025 so they gradually adjust the allocations to less risky assets as the fund gets closer to the intended retirement date.

 

Both of these approaches are good. Just choose something that works for your situation and don’t let yourself get too worked about changes in the market. Do some research, choose an allocation that works for your situation and stick with it. 

 

Should you try and time the market? 

It’s tempting to think that you can guess the right time to buy and sell things so that you come out ahead of someone who is putting a specific sum in at regular intervals (also known as DCA or dollar cost averaging). Heck, even it comes to mind for me sometimes and I have to remind myself of a few things to rid myself of the temptation.

 

1. No one can time the market. Not you, not the high flying hedge fund manager, not even a sophisticated AI (at least we’re not there yet. And when we do reach that point other sophisticated AIs will make it so that the market can no longer be predicted because they’ll distort predicted outcomes with their own intersecting predictions). You may think it is easy to know when things have gone fully downhill or are at a peak that is going to tumble at any moment but it isn’t and you simply can’t know the optimal time to invest.
2. You earn dividends from holding stocks. If you’re holding off on buying you’re losing out on potential appreciation for your equities and you’re also missing out on earning income from those stocks.
3. By committing to a specific sum at regular intervals you’re taking emotion out of your investing strategy and naturally mitigating your risk of buying at market highs. Your investments will gradually grow as a result of your contributions and long term growth in the market.

 

Time in the market beats timing the market. Since you can’t guess where peaks and troughs are going to be, your best bet is to choose a regular amount to invest with at your given allocations and play the long game. 

 

Here’s a visual representation (https://imgur.com/gallery/BlK4jzM ) of a few different people who either pursued DCA, got extremely lucky with timing the market or unlucky with timing the market. I found it to be very helpful in demonstrating the upsides of such a strategy.

 

As an additional example, Fidelity found that their best performing investors were actually ones who had passed away. Since they were dead they weren’t there to jump in and fiddle with their investments and they stuck to the strategy they’d chosen initially (https://www.reddit.com/r/financialindependence/comments/4u4pd3/article_2014_fidelitys_best_investors_are_the/)

 

More resources on DCA:

https://www.reddit.com/r/financialindependence/comments/c02ml4/timing_the_market_the_absolute_worst_vs_absolute/?sort=top

https://www.nerdwallet.com/blog/investing/dollar-cost-averaging-2/ 

 

Who should I invest with?

I would recommend using Vanguard because they are owned by the shareholders of their funds (https://about.vanguard.com/what-sets-vanguard-apart/why-ownership-matters/) this means that they will always act in your interest instead of making plays to gain market share and then taking advantage of their consumers in the future. Additionally, they are consistently the best or one of the best with regards to fund choices, expense ratios and customer service.

 

If you do want to play the game of switching providers if you are being mistreated, then Schwab or Fidelity are good choices (more to consider here – https://www.bankrate.com/investing/best-online-brokers-for-mutual-funds/). Do bear in mind that there is a chance that you’ll need to shift your accounts in the future which can be a headache (although it’s a small risk if you choose a reputable provider). 

 

Generally, you should choose a provider who will be able to give you access to the range of investments that you want to put your money into.

What options do you have available to you for employer controlled, non-taxable investments?

Given that you’re choosing where to put the investments that you have control over (any non-employer controlled plan) this mostly applies to things like your 401k where you can’t choose who you’ll be investing with.

 

For example, my company recently switched from Vanguard to Fidelity (which sucks for me since I prefer Vanguard). They had a bunch of terrible funds with really high expense ratios but i was able to filter down the choices available to me to get to a mix of funds that was roughly representative of what I’d been putting my money into at Vanguard (add details on this process – three fund mix).

 

You’ll want to look for a mix of diversified index funds with low expense ratios (should not exceed 0.5% and ideally are below 0.15%) that match your asset allocation targets.

 

In short, your options may be limited depending on where your employer has chosen to set up your 401k but you can usually work within those constraints to set up a mix of funds that is decent overall. Your available options would have to be tremendously bad to warrant not putting money into that 401k at all (due to the tax advantaged nature of the contributions you make to it and the potential for employer matching).

Will you want to adjust your risk profile over time?

As you get closer to your planned retirement date, the number of years in which you’ll be earning income will decrease as will the years left until your retirement. This will have the dual impact of you not being able to recover as easily from a reduction in value of your assets by putting aside money that you’ve earned or simply waiting for your assets to recover. Because of this, you’ll likely want to reduce the riskiness of your investments as you get closer to your retirement age. 

 

I would recommend using Vanguard’s target retirement funds as a guideline for the allocations that your investments are composed of as you get closer to your planned retirement age. See them here (https://investor.vanguard.com/mutual-funds/target-retirement/#/) or look at the breakdown of allocations by years to retirement that I put together here (https://docs.google.com/spreadsheets/d/1wM4UqiUoNRLeLBXFf18LndKSJccok_iwXheELCisaY4/edit?usp=sharing). 

 

Years to Retirement	Stocks (%)	Bonds (%)	Short term reserves (%)
0	51.4	48.59	0.01
5	61.11	38.88	0.01
10	68.47	31.51	0.02
15	75.84	24.14	0.02
20	83.38	16.6	0.02
25	89.83	10.15	0.02
30	89.81	10.15	0.04
35	89.79	10.15	0.06
40	89.81	10.14	0.05
45	89.88	10.12	0

 

As you can see from the table, Vanguard’s allocation remains at 90% stocks, 10% bonds from 45 years to retirement all the way up until 25 years to retirement. It then moves to 16% bonds with 20 to go, 24% with 15, 31% with 10, 38% with 5 and 48% with 0 to go.

 

Again, if you don’t want to be as involved in the regular management of your funds, you can just choose a target retirement fund with good investment strategies and a reasonable expense ratio and let it take care of things. Otherwise, you can check in on an annual basis and gradually increase your holdings of bonds in accordance with your reduced risk appetite as your retirement date nears.

Links

International vs. Domestic (US) Equity Allocation

Where should you put your money after expenses?

So you’ve got some money left over after paying for your expenses. Congratulations! Now you should start thinking about what you’re going to do with that money. Thankfully, the process is fairly simple and it’s mostly just a waterfall approach. My advice would be to roughly follow this order:

 

• Pay off high interest debt (credit card, some types of loans)
• Build an emergency fund
• Put money into tax advantaged savings
• Pay off low interest debt (depending on your preferences and whether it brings you emotional relief)

 

Pay off high interest debt

Paying off high interest debt seems fairly obvious given that it is probably causing you a ton of stress and is actively draining the money that you’re earning on a regular basis. Another bonus of paying off high interest debt is that you’re effectively getting a guaranteed return of whatever rate of interest you’re paying on that debt. There are essentially two ways to go about paying off your high interest debt.

 

• Highest to lowest prioritization (HLP)
• Snowball approach

 

HLP involves paying off your debts in order of whichever debt has the highest rate of interest.  The snowball approach is where you tackle your debt in the order of total dollar value of the debt. 

 

HLP is more financially efficient as you’ll be taking the most efficient path towards reducing the amount of money you’re paying (or debt you’re amassing) by hitting the highest rate debts first. The snowball approach is generally less efficient because you won’t necessarily be tackling your highest rate debts first but it can be better for a few reasons:

 

• You find it motivating to settle individual debts and thus continue with the process of paying off debt more consistently than you would have otherwise
• There are debt servicing costs aside from a strict interest rate (for example a flat fee per period + the debt rate %) that make the effective interest rate for that debt higher.
• Hitting your smaller debts first gets your count of outstanding debts down and allows you to better manage payments and compliance (thus making you less likely to get hit with late fees, minimum payment fees, etc).

 

Build an emergency fund

The concept of an emergency fund is to have a decent chunk of money on hand to be able to handle unexpected expenses that come up and avoid you falling into debt or being forced to make suboptimal decisions (like taking a high interest short term loan or accepting a job that will put you in a tough position).

 

The basics of setting up an emergency fund are:

 

• Collect enough cash on hand to pay expenses for several months
• Keep your emergency fund in an account where it is liquid (immediately accessible) and won’t fluctuate in value

 

Collect enough cash on hand to pay expenses for several months

Returning to the concept of your appetite for risk we’ll be using that again to determine how many months of expenses you should be holding onto in your emergency fund. I’m moderately risk averse so I choose to hold about 6 months of expenses in my emergency fund. The 6 – 12 month range is generally what the recommendation is with regards to holding funds in an emergency fund.

 

If you have relatively low expenses or are able to quickly reduce them you may want to consider holding fewer months worth of expenses in your emergency fund. On the other hand, if you have high expenses or others relying on you (your family, your parents, your partner) you want to hold more cash in your emergency fund (up to 12 months).

 

Another thing to consider with regard to how many months of expenses to keep is the emotional benefit of having a certain number of months of money on hand for expenses and the peace of mind that comes with it. If you get nervous only having 6 months of expenses on hand then it may be worth it for you to hold 9 or 12 months worth just for peace of mind.

 

The last thing you’ll want to consider is that you won’t want to go too far over a reasonable amount of cash to hold because the cash that you’ll be holding in your emergency fund won’t be earning the same returns that your investments will be and may lose value as a result of inflation over time.

 

Keep your emergency fund in a place where it is liquid and won’t fluctuate in value

This is a very important part of setting up a successful emergency fund. You need your fund to be accessible so that you can quickly pull out money to settle large expenses that may come up. Not putting it in something where its value won’t fluctuate is also important because you want to be able to count on having a reliable source of cash if the need does come up.

 

I would recommend finding a bank with a high yield savings account that you can place these funds in. Currently, there are many options where your cash will be earning over 2% per year but still be immediately accessible (there are some good options here – https://www.doctorofcredit.com/high-interest-savings-to-get/). Choose an account that suits your needs and build up your emergency fund there. I chose Ally Bank as its the right balance of a decent rate, few fees & good online banking features.

Put money into tax advantaged savings

Tax advantaged savings are things like your IRA, HSA and 401k (more types of accounts exist but they are more niche. See a list here – https://en.wikipedia.org/wiki/Category:Tax-advantaged_savings_plans_in_the_United_States). You’ll want to prioritize putting money into these for a number of reasons:

 

• You’ll lose your annual contribution room (for folks in the US, other countries have more intelligent systems that allow you to use room from prior years) for the various accounts if you don’t fund them within the year. 
• These accounts are like amplifiers for your savings because they give you value immediately (in the form of reduced taxable income or tax free growth)
• Some tax advantaged savings will have a % of contributions matched by your employer (depends on your employer).

 

You’ll lose your contribution room

All of the tax advantaged savings in the US are set up on a calendar year basis. So you’ll get a new chunk of contribution room once a new year begins. If we take a 401k for example, you have $18,500 (more room is available through a Roth Mega Backdoor but that is a whole other topic – https://www.madfientist.com/after-tax-contributions/) in contributions that you can make over the course of a given year. So, if you’ve made $17,000 in contributions by the end of 2019 you’ll immediately have another $18,500 of room to make contributions once you hit January 1st, 2020. 

 

It’s important to be mindful of the tax advantaged accounts that you have access to, your available contribution room and how much you’ve contributed to date to gain the most that you can from them on an annual basis.

 

Common tax advantaged accounts, limits and contribution methods

• IRA (Traditional and Roth – https://www.irs.gov/retirement-plans/traditional-and-roth-iras)
  • Annual limit
    • $6,000 (changes occasionally based on cost of living adjustments)
  • Contribution methods
    • Set up an IRA with a bank or investment firm and contribute to it whenever you like
  • Contribution window
    • For a given tax year, contribute to your 201x IRA by April 15, 201x+1. For example, for the 2019 tax year contribute by April 15, 2020.
  • Available providers
    • Given that you’re the one setting up your IRA and you have complete control, you’ll be able to go with whichever provider you desire. I recommend Vanguard for their low cost index funds and company structure.
  • Requirements
    • No requirements other than you need to open the account yourself.
• 401k (Traditional and Roth – https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits)
  • Annual limit
    • $19,000 (changes occasionally based on cost of living adjustments) in contributions that you can make directly yourself. Up to $56,000 in contributions between you and your employer can be made. See info on the Mega Backdoor Roth (https://www.madfientist.com/after-tax-contributions/) and Solo 401Ks (https://www.reddit.com/r/financialindependence/comments/984lax/for_firehopeful_sidefreelancer_whats_best/) to better understand how you might be able to take advantage of this extra contribution room.
  • Contribution methods
    • You can only put money that you’re earning through your paycheck with an employer into your 401k. You do this by choosing your contribution amount (either as a % or dollar amount) on a per paycheck basis.
    • You can max out your 401K earlier in the year if you like. Generally I would advise to spread out your contributions roughly evenly over the course of the year but the flexibility is nice (if you’re planning to quit before the end of the year and you have a good match, for example).
  • Contribution window
    • Given that you can only contribute with dollars earned on your paycheque you’re naturally limited to money earned over the course of a given tax year with your employer(s).
  • Available providers
    • The 401k provider you’ll be using will be determined by your employer. If you are setting up your own 401k you’ll be able to choose yourself (I recommend Vanguard).
  • Requirements
    • Employer must have a 401k plan set up that you can contribute to.
• HSA (https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/2019-hsa-contribution-limits-rise-irs-says.aspx)
  • Annual limit
    • $3500 self only
    • $7000 family
  • Contribution methods
    • Similar to the 401k, you can contribute to your HSA through your paycheque. You can choose a % of dollar amount contribution. 
    • One big difference, however, is that you cannot contribute more earlier in the year to max out before the end of the year. Your contributions are bound in a way where you can only max out by the end of the year. This means that for a self only HSA you can contribute a max of 145.83 per paycheque (assuming you get paid twice per month).
    • You can also contribute directly to your HSA but it depends on the terms of your account (usually dictated by your employer). Find out more here (https://finance.zacks.com/contribute-pretax-dollars-hsa-1762.html).
  • Contribution window
    • Same as for an IRA. For a given tax year, contribute to your 201x HSA by April 15, 201x+1. For example, for the 2019 tax year contribute by April 15, 2020.
  • Available providers
    • The range of providers that you’ll be able to choose from depends on your employer. For example, with my employer, I must use HSA Bank for my HSA.
  • Requirements
    • Being able to contribute to an HSA has requirements in terms of the health insurance that you’re using (requirements listed here are for self only plans):
      • Your minimum deductible must be $1,350 or higher
      • Your out of pocket max must be lower than $6,750

 

There are more plans which I may cover in the future but these are the most common ones that you should be aware of.

 

One important note is to be aware of the fees and choices within accounts that are chosen for you by your employer. Some 401ks, HSAs and other accounts where you can’t choose your provider may have pretty bad arrangements (poor funds to choose from, high fees, etc) that make them less desirable to put money into. You should do a rough comparison vs. your other options before choosing to put money into them and move your money to a better place as soon as you have the opportunity.

 

For example, if you have the choice of a 401k where the lowest fee index fund for the domestic stock market is 2% and an equivalent fund at Vanguard charges you 0.01% you’ll want to consider the cost of that 1.99% fee difference vs. the benefit you’ll get from putting your money into that form of tax advantaged savings.

These plans are amplifiers for your savings

Generally tax advantaged savings offer one of two features

 

• They reduce your tax liability for a given year (usually labelled as Traditional)
• They allow money placed into them to grow tax free (usually labelled as Roth)

 

Because of this aspect of your tax advantaged savings, every dollar you put into them has a larger impact than simply putting money aside into, what is termed, taxable investments.

 

Some quick examples for the purpose of illustration are:

 

On the Traditional (tax liability reduction) front 

If you were to make the full $6000 contribution to your Traditional IRA for the 2019 tax year you’d be able to reduce your Adjusted Gross Income (the amount of money you made in the year that you’re ultimately taxed on – https://www.irs.gov/e-file-providers/definition-of-adjusted-gross-income) by those $6000 dollars. This means that the taxes you’ll owe for that year will be reduced by the deduction you’re making ($6000) times your marginal tax rate (the rate you’re paying for the bracket you’re in. See tax brackets here – https://www.nerdwallet.com/blog/taxes/federal-income-tax-brackets/). So for someone who has an AGI of $100,000 they would be paying a marginal rate of 24% on their income to the federal government. By contributing $6000 to a traditional IRA they’ll be saving $1440 on their tax bill for that year.

 

However, when you do eventually withdraw money from your Traditional IRAs all of it will be considered income for that given year and be added directly to your AGI (https://www.investopedia.com/articles/personal-finance/021015/how-much-are-taxes-ira-withdrawal.asp).

 

Finally, be mindful that Traditional contributions have restrictions on when you can access them. Essentially there are penalties if you withdraw from them before you reach the age of 59.5 (there are also some special cases you can read about here – https://www.nerdwallet.com/blog/investing/ira-distribution-rules/ | https://www.thebalance.com/how-to-withdraw-money-from-a-401-k-or-ira-2894212). So, if you might need the money that you’re putting into a Traditional tax advantaged savings you may want to consider going with a Roth contribution or building up your savings funds first before putting money into Traditional tax advantaged savings.

 

On the Roth (tax free growth) front

Taking up the example of a full $6000 contribution to your IRA for the 2019 tax year but this time making that contribution to a Roth IRA it would look something like this. Because a Roth contribution doesn’t have an immediate impact on your taxation for the year it’s a bit more difficult to calculate. 

 

However, we can consider a scenario where the $6000 you put into your Roth IRA has grown to $45,000 by the time you’re ready to withdraw from it. Because you put this money into a Roth IRA, you get to withdraw it without any taxation. In a scenario where you have a marginal rate of 24% and you’re withdrawing $10,000 you’d be saving $2,400 in taxes that you would have otherwise had to pay for that given year.

 

The more tax you expect to be paying in the future and the more you expect your Roth tax advantaged savings to grow before you pull from them the more that you’ll be interested in putting your money into this savings vehicle.

 

Roth contributions also have the upside of being less restrictive than Traditional contributions which can involve penalties for early withdrawals (i.e. withdrawals before retirement age). As long as you’re pulling out your contributions (what you put in earlier on an annual basis) and not your earnings you can withdraw tax free. However, if you do withdraw early, you won’t be able to put that money back in and allow it to continue to grow tax free (see here for more information Roth – https://www.nerdwallet.com/blog/investing/roth-ira-withdrawal-rules/ )

 

What kind of tax advantaged savings should I choose?

Generally, the guidance that people will give you is to choose Roth contributions if you think you’ll be making more money in the future and to choose Traditional contributions if you believe you’re approaching your peak earnings.

 

I choose to maximize a Traditional contributions where I can because I put value into having my tax burden being reduced immediately for the given year. Because of my income, I’m not eligible for Traditional IRA contributions but can contribute to a Roth IRA by using the Backdoor Roth method (https://www.physicianonfire.com/backdoor/) . So in my scenario I am maximizing the contributions available to me on the IRA and 401k front in this fashion (this example is for the 2019 year):

 

• 401k – $19,000 in traditional 401k contributions (+ whatever my employer will match)
• IRA – $6,000 in Roth contributions (made with the backdoor Roth contribution method)

Which puts me at 76% Traditional and 24% Roth contributions on an annual basis. You could model out what approach would be best for you by considering what your tax burden (AGI based * your tax rates based on your expected income for a given year) reduction from contributing to Traditional sources would be vs. the taxes you’d expect to save from the tax free growth of your Roth contributions (based off of how much you’ll be contributing, the rate at which your investments grow and what your tax rates will be in the future). 

 

I may undergo that exercise myself at some point as well. But, for the time being, just putting money into tax advantaged savings is a huge step forward so don’t get too caught up in Trad vs. Roth contributions.

Contribution matching

One thing you’ll want to consider when deciding where to put your money is whether or not your contributions are being matched by your employer. Some employers will match money that you put into your 401k or HSA accounts (most common cases). In those scenarios, you’ll almost certainly want to favour putting money into those accounts to max out your available match (as it is guaranteed growth for the money that you’re putting aside) and then follow whatever order makes sense once your available match has been maxed out.

 

An example of a matching system is where your employer matches 100% of your 401k contributions up to 4% of your salary. So, if you have a salary of $100,000 your employer would match the first $4,000 (100,000 x 0.04) at 100%. This would leave you with $8,000 in your 401k for that given year with you only having put $4,000 of your money into it.

 

Occasionally, you may not want to pursue contribution matches as a priority if the terms or circumstances surrounding them are not particularly favourable. For example, some companies offer matching for your 401k but make you wait 2 years for it to vest. In that case, you may still want to prioritize your 401k but there could be scenarios where you aren’t planning to stay the full 2 years for the vest and it doesn’t make sense to you any longer.

 

Additionally, you may get matching for your 401k or HSA but there could be monthly fees or high expense ratios for the funds that you are able to invest into that make it so you’re better off pursuing other options available to you first.

 

Put your money into your chosen investment mix with taxable investments

Investments and investment choices are covered in great detail under the “How to make your investment choices post”. Essentially, once you’ve got a sense of how much money you’re saving per month in excess of your expenses and you’ve worked through the previous 3 steps (pay off high interest debt, fill up emergency fund, max out tax advantaged savings) you’ll want to start putting that extra money into your investments.

 

I’ve set up my investing to put money into the funds at Vanguard that I’ve selected once every two weeks. That way I’m continually adding to my investments at a regular contribution amount that works for me and I don’t have to think about it.

Pay off low interest debt

This one is interesting because carrying low interest debt isn’t necessarily a bad thing but it can make sense to pay it off before putting money into investments depending on your circumstances. For example if you have a mortgage, car loan or student loans you might find some reassurance from having those debts paid off before pushing the majority of your money into investments.

 

I would generally classify anything near the rates that you’re getting in a high yield savings account (currently ~2-2.5%) as low interest debt.

 

You’ll want to consider a few things before choosing to put money into your low interest debts:

 

• How does carrying this low interest debt make me feel?
• Are there any fees or disadvantages with overpaying or fully paying off your debt early?
• What are the consequences of not paying this debt for an extended period of time?
• How do my alternatives compare?

 

How does carrying this low interest debt make me feel?

To me, this is the most important question to ask yourself. Does having low interest debt to my name stress you out? Does it make you unhappy? Depending on the answers to those questions you may want to seriously considering just paying it off. Of course, it’ll be a question of feasibility but you can include this course of action in your financial plans to make progress on it.

 

For example, you might have $40,000 in student loans that have an interest rate of 2%. In terms of debt that’s a fairly low interest rate and the payments would be manageable but it might just irk you that this debt exists and you’re beholden to it. Given that paying off $40,000 could be something that someone could achieve in a reasonable time frame you could then target those loans with increased payments with the goal of having them paid off in 3 years rather than 10 (or whatever the horizon happens to be).

 

However, do know that you’ll likely be getting a worse return on paying off your low interest debt aggressively (at a rate exceeding what you need to pay to avoid extra fees & costs) vs. the other alternatives available to you so you should mostly only consider this when you’ve reached the point where you are putting money in taxable investments. At that point, there’ll be a tradeoff in terms of the returns you’re getting (likely lower returns as compared to taxable investments) but the peace of mind and financial security may make it worth it for you.

 

Are there any fees or disadvantages with overpaying or fully paying off your debt early?

Let’s say you have some low interest debt that you’d like to get rid of. Before doing so you should consider the potential downside of paying it off. An example could be early payment penalties for certain mortgages where they don’t allow you to pay off your mortgage before a certain time (or make extra payments). Another example would be paying off your student loans could have a temporary negative effect on your credit score (https://www.reddit.com/r/personalfinance/comments/97w13c/does_paying_off_student_loans_hurt_credit_score/). A final example would be paying off your mortgage early and no longer being able to take advantage of the mortgage interest deduction (https://www.nerdwallet.com/blog/mortgages/mortgage-interest-deduction-changes/). 

 

None of these reasons could be substantial enough to warrant not targeting your low interest debt more aggressively but you’ll want to be aware of potential downsides before pursuing a particular course of action. 

 

What are the consequences of not paying this debt for an extended period of time?

Is there a downside if you’re going to let your low interest debt stick around and continue making payments at the rate that you’re meant to make them? Is there a chance that your rates could go up? Does having that debt keep you locked in a certain situation and limit your opportunities? 

 

If your debt is somehow preventing you from accessing a different opportunity (renting somewhere new, getting a mortgage, getting a certain job) then that inaccessible opportunity may provide more value to paying off your debts early.

 

Sometimes debt can be limiting in ways beyond the required payments and interest that is collecting on it. Depending on what your situation is, it may make sense to pursue paying off low interest debts ahead of schedule with future needs in mind. 

 

How do my alternatives compare?

I touched on this in the first point but you should be aware of how your alternatives compare. If you’ve got an investment mix that you’re expecting to earn 7% on an annual basis with (vs. the 2% effective return of paying off your debt) you may just want to focus on those investments.

 

Generally, if you’re mentally ok with carrying some portion of low interest debt and expect that you’ll be able to handle making payments on time for the foreseeable future then it makes sense to hold off on pursuing that debt aggressively.

 

Links

International vs. Domestic (US) Equity Allocation

Saving for the Future

The basics of saving for the future are to

1. Determine what kind of life you want to live and examine ways to accommodate the future in your present
2. Examine your current financial situation
3. Take note of any goals you may have for the future
4. Make adjustments to your lifestyle based on what your goals are

What kind of life do you want to live?

Do you want to live a life where you eat out often? Or spend a lot of money on shows & other forms of entertainment regularly? Would you prefer quiet nights at home and borrowing books from the library? Do you like to cook or have your meals be pre-prepared?

All of those preferences and decisions are fine. Just know that every decision, regular habit and recurring expense is going to shape the way that you save for your future and the kind of future you’ll have. Essentially, the more you spend of your income now – the less you’ll have for later. That being said, you shouldn’t sacrifice the core things that make you happy. Generally, you should be able to reduce your expenses to a certain point without losing the things that spark joy (thanks Marie Kondo!).

 

For example, let’s say you have an awesome group of friends that you hang out with regularly. Those hangouts generally compose of going to a great restaurant where lots of delicious food and compelling alcohol is consumed. These nights bring you and your friends a lot of happiness and foster an ever deepening friendship. The downside of these nights is that it runs at about $60 per person every time you go. 

 

An example of reducing expenses without losing what makes your life wonderful would be to take on hosting those friend nights at your place (or take turns hosting) and experiment together with cooking meals that you can still enjoy. Plus, alcohol is much less expensive when not being purchased at a restaurant, :). That way you can still hang out together, learn to cook and even expand the range of activities you do together (board games, video games, cards, movie nights).

 

This sort of thinking can be applied to many situations. What is it about an activity that makes you enjoy it so much and spend money on it regularly? Is there a way to get that same enjoyment at a reduced cost? Sometimes the answer is yes. Sometimes the answer is no. But you can examine your major expenses and adjust accordingly. You may be surprised at how much progress you can make. You may even learn some new things in the process!

 

By thinking through how you’re spending you can live in the present while taking into account the future. It is a bit intimidating, but every dollar spent now is a dollar that you can’t put towards your future self (and have grow alongside you in the form of investment returns). You’ll want to balance things in order to avoid over committing to one or the other (present or future). I’m still figuring out that balance myself!

 

How are you currently doing financially?

So you’ve thought about what kind of life you want to live and where your major sources of expenses might be coming from. Here’s the fun part. You’ll get to look at the actual data tied to the decisions you’re making and see if your assumptions line with reality.

 

What you’ll want to do is figure out how much money you are getting after withholdings from your paycheque and then see how much of that you are spending on a monthly basis. Hopefully, you’re spending less than you’re earning post tax (if you’re not, you’ll need to consider if you need to dial back things in order to live within the limits of your current income). 

 

Once you have your post tax income (the money that shows up in your bank account after every paycheque) you can see how much of that money tends to go towards expenses and how much you have left over. That amount of money in % percentage form (e.g. $1000 post tax, $400 after expenses would be 40%) is what people typically refer to as their savings rate (https://www.reddit.com/r/financialindependence/wiki/faq#wiki_how_do_i_calculate_my_savings_rate.3F). Some people like to track savings rate and find it motivating to see it increase as they make changes or keep their spending flat even when they’re getting raises.

 

The next step is to dig into your expenses to better understand how you come to that savings rate number. It may be helpful to use something like Mint (https://www.mint.com/) or Personal Capital ( to import your transactions and bunch them into categories. If you’d rather not sign up for a service and share your information it is totally doable to download transactions in CSV form and play around with them in a spreadsheet (typically I use Google Sheets or Excel for this).

 

Once you’ve roughly categorized your expenses you should be able to put together a breakdown that looks something like this.

 

Post tax income (monthly) – $3000

Rent – $1900

Utilities -$ 100

Food – $400

Entertainment – $100

Travel – $200

Health and Fitness – $75

Transportation – $150

 

This sample breakdown sums up to monthly expenses of $2925 which leads to a 2.5% savings rate. Once you have this big picture you can dig into what you should do next. For example, in this scenario we’re dangerously close to spending past what we’re earning on a monthly basis. Given how big of a contributor Rent is, we might want to look into that category first and see if there are improvements to be made.

 

Some additional categories that you might include could be things like Children and

Education. You may also want to break categories down further depending on where your expenses are coming from. For example, if you buy groceries and spend a lot on eating out it could be good to break those down separately in order to better understand where your spending is coming from (too much eating out vs. spending too much on groceries). 

 

For significant intermittent expenses that don’t come up monthly (like Travel) you can average them out on a monthly basis based on spending over the course of a year. Your expenses will vary based on your situation and your treatment/examination of them should as well!

 

Once you’re at a good point with regards to your spending vs. what you’re earning on a monthly basis you can then look at where your excess money should be going!

 

Do you have any big goals for the future?

Do you want to buy a home for yourself at some point? Return to school? Have a kid? Go on a long trip? Retire by a certain age? All these things require a decent amount of money to be saved up in order to be pursued successfully. With that in mind, it is helpful to think about how you might get there and how long it will take.

 

There are a few components to planning savings for goals in the future

 

• How much do you need to meet your goal?
• When will you need the savings to be available for your goal?
• At what rate will you need to draw down from those savings to attain what you’ve been saving for?

 

How much do you need to meet your goal?

For example, if you’re looking to buy a house you might consider roughly what kind of house you’d like and what sorts of areas you’d be interested in buying in. With a bit of research you can settle in on a rough range of prices you’d be willing to consider and then decide on how much of a down payment it makes sense for you to put down upfront. With that in mind, you’ll know how much you’ll need saved by a certain point in time and you can start planning towards it.

 

Let’s take the purchase of a $500,000 home for example. 

 

Using a 20% down payment as our baseline (lower interest rate, avoids PMI – https://www.reddit.com/r/personalfinance/comments/7poswg/how_much_is_an_actual_reasonable_down_payment_on/) we’ll need $100,000 on hand when purchasing the house. We should add another $15,000 in closing costs for the various things you need to pay for when buying a home (inspection, agent fees, lawyer, etc – https://www.nerdwallet.com/blog/mortgages/really-costs-buy-home/).

 

At that point it just becomes an equation to determine at which point you’ll be able to reach your goal. Take your excess, post-tax income that you’re saving on a monthly basis (let’s use $3000/month for simplicity) and divide your savings goal by that (in this case, 115/3 = 38.33 months or almost 4 years).

 

Seeing how long it will take you to save up to your goal may provide you with an impetus to reexamine how you’re spending money in order to get there quickly, give you some encouragement that things are more attainable than you thought or lead you to decide to focus on other goals in the meantime.

 

For something like saving up for a house, you may be looking at a long time horizon which leads into my next question.

 

When will you need the savings to be available for your goal?

Generally, as you’re saving you should be putting money into your chosen allocation of index funds (more on that later) but you may want to alter how you’re saving up money based on when you’re anticipating you’ll be needing it.

 

In the case of saving up over the course of 4 years for a downpayment for a house you’ll likely want to choose to save your money in a form that makes sense in relation to your time horizon. If you take the simple math that we did previously, $115,000 / $3,000 per month you get 38.33 months. However, it isn’t quite that simple as there are a few things that could lead to a different outcome.

 

Given that you’re waiting 4 years before you have enough money to buy this house:

 

• The cost of the type of house that you’re interested in could change between now and four years from now
• Your money could increase (or decrease) over time depending on how you’ve decided how to save (or invest) it.

 

Which brings us back to a form of storage for your money that makes sense for you and your situation. In the case of a house that takes a long time to save up for, you’ll probably want it to be in a place where it is working for you (i.e. earning returns) while you’re working toward your goal. 

 

Generally, when it comes to investing money you’ll want to find the investment opportunity that matches your risk tolerances. Riskiness of your various money storage options are as follows (least risky to most risky):

 

• Cash holdings (checking account, actual cash on hand, etc)
• Bonds
• Stocks (also known as equities)
• Real estate
• Private company shares

 

Another rule of thumb is that, the more diversified your investment is, the less risky it becomes. So, even though stocks are generally riskier (and provide higher returns) than bonds, holding a stock index fund could be less risky (and provide a lower return) than an individual bond.

 

With that in mind, you may want to pursue a strategy where you put your money into more volatile investment types earlier on as you’re saving up and gradually move into a less risky allocation as you get closer to your savings goal (and to wanting to be able to actually spend the money you’ve been saving up).

 

In the case of saving up for this house, you could do the following:

 

• Invest in equity index funds (100%)
• Invest in equity index funds (50%) and bond index funds (50%)
• Sell your investments and move your money into a high interest savings account or term deposit (if you know exactly when you’d like it to be available)

 

With this strategy, you’d be able to get much higher returns on your money as you’re saving up vs. storing your savings exclusively in cash (see this chart – https://novelinvestor.com/asset-class-returns/ – to see how returns tend to vary by asset class). However, there is a downside as there is always a chance that your investments will decrease in value as you’re saving up. We’re trying our best to mitigate that risk by reducing the risk of the holdings as we approach wanting to make use of them but you can never guarantee returns from an investment (despite what anyone tries to tell you).

 

In short, depending on how long you need to save for to reach your goal you should invest in appropriately risky asset classes in order to make use of the returns you can earn on your money over time. As you get closer to your goal it’s best to reduce the risk of your investments to avoid too much fluctuation and end up missing your target (in terms of the timeline you are aiming for).

Do you want to make any adjustments to the way you’re doing things?

Now that you’ve thought through what kind of life you’d like to live, your current financial situation and goals you’d like to reach in the future. You might want to make adjustments to the way that you’re currently doing things in order to get to where you’d like to be. You may also be perfectly happy with the way things are, but if you’ve never thought about this sort of stuff before it is likely that you’ll want to make at least a few changes.

 

If you’re facing a scenario where you’re not progressing towards your goals at a rate that you’d like to you might make some of the following changes:

 

• Change of career for better hours, benefits or pay
• Reduction in non-core expenses (eating out, entertainment, etc)
• Change living situation to reduce costs (move to a smaller place, get a roommate, etc)
• Shed unneeded assets and services (car that you don’t frequently use, subscriptions that you’re paying for but not using, etc)

 

You might also not be moving along at the pace that you’d like but uncertain of where you can make changes without ending up unhappy/sacrificing too much in your life. That’s fine too. Now that you’re aware of the pace that you’re moving at and where you’d like to be you can use that to make more informed decisions about how you choose to live your life!

 

Keep looking for ways to live smarter and get to where you want to be without giving too much of what makes you happy in the present moment. You’d be surprised by what you can find when you start looking at and paying attention to the choices you make.