How To Not Blow 20k

…Over a decade and a half.  I know: bad trick, using the headline that way.

But seriously, lots of people talk about how using low cost investing options is a good idea.  Put your money in index funds rather than actively managed mutual funds or with an adviser.

Why?

One word: fees.

Unfortunately, the investing world does not operate on the, “You get what you pay for principle.”

And, over the long haul, those little fees add up to be a drag on your returns.  How big of a difference?  Let me tell you a story…

 

When I was 18, my Dad gave me a gift that I will never forget.  He started me (now us) on the path to financial independence.

When I was 18, I had my first W-2 job working as a sales associate in the electrical section of the regional hardware store.  (I worked for years before that, but I was always a small amount and paid in cash, so it was never eligible for taxation let alone retirement savings.)  At the then-minimum wage rate of $5.15/hr, I didn’t make much.  But, the little I made was reported to the government as earned income.  “Fortunately,” my earned income was so small, I was ineligible to pay taxes.

I was using the money I earned to pay for some of  my college expenses.  So, my Dad said he would match up to my earned income and put the money into something called a Roth IRA.  Of course, this became table stakes to hold a discussion on the general topic of saving for retirement.  We talked about the differences between a Roth and a traditional IRA.  We talked about contribution limits and the difference in withdrawal rules.  Once, we made it through the lecture, we got into the fun stuff: what to do with the money.  Pretty quickly, we ruled out a down payment on a car or storing it in my sock drawer.  Instead, he suggested investing in a mutual fund, The Growth Fund of America (ticker: AGTHX).  AGTHX is, you guessed it, an actively managed fund.  Its annual expense ratio (one of several potential charges people pay to invest their money) is 0.6%.

So, why is that a problem?

If a typical index fund charges ~0.1% in fees, the observation is that actively managed mutual funds at ~.6% or a human adviser at ~1-2% don’t make you enough extra money in the long run to justify their cost.

Compare AGTHX to Vanguard’s S&P500 index fund (Admiral shares because we’re over $10,000).  The Admiral shares have an expense ratio of 0.04%.  While the Investor shares (minimum of $3000) have an expense ratio of 0.14%.  Last, I checked, 0.6% is more.

But, wait!  You say, “don’t the hotshot fund managers get a better return for their customers?”  How else can they justify charging more?

Maybe…

 

Let’s look at the numbers.

I used Morningstar’s portfolio analyzer to get a bit more information.  Note that it only looks at changes in share prices (no capital gains/dividend reinvestment included).  I simulated buying $100,000 of each fund on Jan 5 of 2001.  How have the two funds done over the past ~15 years?

Source: www.morningstar.com

If you look at a Google Finance image of the two mutual funds’ values over time, it looks kind of like this:

AGTHX vs INX

So, what gives?  For much of their history, AGTHX outperformed VTSAX (the blue line is higher than red line). But, something called “reversion to the mean” seems to have kicked in.  That’s fancy talk for an idea that most investments eventually delivery average performance.  They may out/under perform for years or a decade and a half, but eventually, they produce average results.  This is one of the core reasons for selecting low-cost index funds as your primary investment vehicles.  Over the long haul, if most funds perform similarly, then the lowest cost fund wins. You can read a lot more about this from John Bogle, inventor of the index fund, founder of Vanguard, and personal hero.   While AGTHX may have outperformed VTSAX for many years, in the long run, the two funds have had roughly equivalent performance for over 15 years, yet AGTHX consistently charges fees that are almost 10x higher.

By the way, those fees are pretty insidious.  If you look at your statements, you will not see actual dollar values coming out of your account.  Instead, the fund management team takes them off the top before they show up in any individual statements (I spent a few hours looking through some pretty arcane sections of both American Funds and Vanguards websites before I convinced myself of this).

So, now the conundrum.  I admit, it’s an emotional one.  Math says, roll everything from AGTHX into a lower cost fund (e.g., VTSAX).  Our goal is not to tap these funds for at least a few decades.  So, shedding the fees should be the right decision.  But emotion says maybe those über-smart folks at American will outperform the index once again.  And, what about diversification?  If hackers get into Vanguard, they may not simultaneously get into American.  And besides, my Dad is the one who got this ball rolling, even if I’ve done the vast majority of the contributions.  I feel some (totally irrational) guilt at moving away from this fund.

 

So, what to do?  I’d love some other perspectives…drop me a line in the comments.

 

I Have A Problem

Lunch boxes. Like the one I left at home.

I forgot my lunch the other day.

I’m cheap.

I bought the cheapest sandwich (with a side of carrot sticks) that I could find.  It was going to cost me $5.87.

While standing in line to pay for my lunch, I pulled out my cell phone and divided $5.87 by 0.04 (mental math is not my strength).

My stupid cafeteria lunch just cost me $146.75.

Grrr….

Create Exponential Growth As Quickly As You Can

Mind the gap.

Everyone in the personal finance world has some version of this sentiment, including the folks that run the London Underground.  There are hyper savers and Uber earners.  There are some that are cool with both.  I definitely fall into the third category. I don’t really care how you build a gap between your income and expenses; just make it as big of a gap as possible!

I would like to use this post to explore why it is so important.

Image from Go Curry Cracker. Check out their excellent post on how to achieve financial freedom.

A friend shared this savings curve from the awesome team of Winnie and Jeremy over at gocurrycracker.  I did some additional tracing, and Mr. Money Moustache has a similar post.  He also linked to networthify (not https) which may be the original source for this set of bloggers.  So, let’s dig into this a bit more. First, the graphic itself.
The idea is that if you save x % of your gross income every year (and maintain your current expenses indefinitely), after y years, you will achieve Financial Independence.

  • Mr. and Mrs. Money Mustache completed their journey to financial independence in about 9 years by saving 66%+ (and making a few mis-steps along the way)
  • Jeremy and Winnie completed theirs in 10 years and a day by saving north of 75% of their take home pay (and making some pretty big oopsies of their own)

This was eye-opening for me!  I fancy myself pretty good with money.  Let’s see how we’re doing by this standard.  Here’s our 2016 expenses Paretoed out into big buckets.

And the answer to how well we’re doing is: pretty crappy!  …although, not relative to the average US person, actually.  Turns out on average, Americans only save ~6% of their after tax income.  We’re putting away just over 30% (with a 1 yr old).

Relative to how we were doing pre-kid and compared to other extreme early retirement bloggers, we’re not socking away as much as I would like.  And, you know what?  That’s OK.  We’re parents.   And, this early retirement thing is just creeping into our consciousness.

For another post, I’ll have to dig into what our numbers were leading up to the purchase of the rental property.  Speaking of the rental property, I’m actually a bit more bullish on our ability to retire early because of our real-estate portfolio.  Let’s quote George Box again, “All models are wrong.  Some are useful.”  These models strictly look at investments as having a fixed percent (5%) growth.  They also assume a fixed 4% withdrawal rate in retirement based on your current expenses.  Both are conservative and your expenses may vary quite a bit…I hope we’re not still paying for child care when we retire!

Last thing before I sign off: see how the relationship between savings and time is curved?  That’s because of two basic factors:

  1. Compound growth
  2. Constant expenses

The more you can do to save early, the more your best savings tool gets to work for you.  By the way, it’s the tool that anyone selling you something doesn’t mention: time.  In case you missed it from school, compound growth follows an exponential growth curve.  Practically, that means the more time you give your money to grow, the more it works for you.  Here’s $1000 invested for 20 years at 7% (compounding monthly).

Point two is where this gets exciting.  If your investment grows at an exponential rate and you withdraw at a constant rate, your investment will continue to grow even as it supports your retirement.  There’s some caveats to that, but at it’s core, that’s why the 4% withdrawal rate is such a nice way to plan for retirement.

Think on that for a while.  Then, think about what structural changes you might be willing to make in order to bring retirement closer to today.

Self Directed Retirement

I’ve read more than a few passing mentions of so-called self directed retirement accounts.  I never really understood what that meant.  But the message was usually delivered with lots of exclamation points:

  • As a self employed business owner, you can reduce your taxable income, save for retirement, and increase your capital for investment!
  • As a full time employee with a side hustle, you can direct your retirement savings into your side business!

See!?  Why are you still reading these words?  Who wouldn’t want to have a self directed retirement account?  Why haven’t you called a broker yet?

 

Not so fast. Let’s dig into this a bit further.

Disclaimer.  Keep in mind: I’ve never formally studied retirement planning or financial advising.  Any decisions you make are your own. 

Let’s start with my motivation: with a potential opportunity to acquire our second (and maybe third!) on the horizon and a need for more cash, I figured it was time to figure out how we could afford our next opportunity.  And, a self-directed IRA represents a way to get cash without selling a kidney.  Here’s what I found:

 

 

What is a self directed IRA? 

It is a tax-advantaged (tax deferred) account offered by the US Government (IRS).  The account requires a custodian and allows for investment into alternatives (e.g., real estate, notes, or private companies). The account is funded with pre (traditional-IRA) or post (Roth-IRA) tax dollars.  The account then grows or shrinks as your investment choices grow or shrink and is subject to similar tax rules with a few extras.  For example, a self-directed IRA is prohibited from a bunch of transactions with “disqualified persons,” namely anyone closely related to you or businesses where “disqualified persons” have more than a 50% stake.

Honestly, It’s a bit tough to find details on the IRS’s website in one place (odd, right?).  I found that the fine folks at Cornell Law publish the internal revenue code  from which all the retirement accounts are authorized.  And, there’s an innumerable set of documents that the IRS publishes on all manner of arcane tax rules.  I also found IRC 4975(c)(1) and IRS Publication 590 to be the most referenced ones.

I did find a bunch of company websites that are selling their services as custodians.  Note: I’m not affiliated with any of these companies, nor am I receiving any compensation for mentioning them.  Some of these have pretty thorough documentation of the ins/outs of a self-directed account.

OK.  Enough overview.  I want to buy real-estate with my retirement dollars already.

 

 

Why is a self-directed IRA useful?

You can invest your retirement dollars into a wider variety of investment types.

Typical retirement accounts (401(k), 403(b), IRA, Roth IRA) are set up through an investment company like Vanguard, Fidelity, etc.  In a typical account, you can choose to put your money into stocks, bonds, mutual funds or other publicly trade-able assets.

I don’t want to do that. I want to buy a building or a note or shares of Tesla before they went public, and I want to do it with my retirement dollars.  This site lists a bunch of different types of assets (some of which you can invest in through traditional IRAs):

    • Real Estate
    • Private Company Stock
    • Tax Liens & Deeds
    • Oil, Gas & Mineral Rights
    • Crowdfunded Ventures
    • Trust Deeds & Mortgages
    • Private Loans to Businesses or Individuals
    • Venture Capital
    • Precious Metals
    • Traditional Stocks, Bonds & Funds
    • Anything the IRS rules allow for

Here’s one of the exciting benefits of using retirement dollars this way: your self directed IRA can get a non-recourse loan to finance the purchase of a property.  What!?  Well, yes.  You have to find a lender comfortable with this, and at typical loan to value ratio is closer to 50% but, it sure looks like you can leverage your retirement dollars.

One of the biggest reasons to look into a self directed IRA is if you are self-employed.  Lets say I decide to “retire” early from my day job to manage my real estate portfolio.  The self-directed approach allows me to continue putting aside retirement dollars, and I could elect to simultaneously supercharge my real-estate holdings.

There’s a few different flavors of self directed accounts: a solo 401(k), a self directed LLC (typically with “checkbook control”), or a business funding IRA.  I’ll leave the detailed overview to you to click through the links.  Suffice to say that each has minor differences in rules and benefits.

How to get started?

Think of setting up a self-directed IRA as starting a business.  That looks closer to the level of complexity to expect.
First, you need a custodian company that does this sort of thing.  Vanguard, Fidelity, Charles Schwab aren’t the go-to places for this kind of investment.  Some of the linked companies in this post are a good place to start your research.  Here they are:

How to fund a self-directed account?

Once you have your account set up, there are two basic ways to add funds into the account

  1. You can convert an existing retirement account into a self directed one.  This will of course require the support of your custodian company. And, all the IRS rules about taking possession of the funds apply.
  2.  Once the account is set up, you can start contributing much as you would a regular IRA.  The specifics will vary depending on which account custodian you’ve chosen.

How do you get your money out?

The short answer is just like any other retirement account: you cannot.   The longer answer is that you cannot until you reach the minimum age to begin distributions without paying a penalty (all the usual IRS rules apply regarding early withdrawals).

So you’ve invested in a nice little rental property.  You’re earning a great return on your investment.  What do you do with the proceeds?  You can either re-invest in the existing property (e.g., pay down any non-recourse loan balance) or save the cash to buy your next property!  Either way, don’t just take a distribution without ensuring you understand the rules or you may end up paying a penalty and income taxes.

Some other pitfalls of a self-directed account:

  • Cannot use money to interact with “disqualified parties.”  For reference, here’s the list of folks who cannot interact with the funds in the plan:
    • The IRA owner (don’t think you’ll buy a beach rental for your family this way!)
    • The IRA owner’s spouse
    • Ancestors (Mom, Dad, Grandparents)
    • Lineal Descendents (daughters, sons, grandchildren)
    • Spouses of Lineal Descendents (son or daughter-in-law)
    • Investment advisors
    • Fiduciaries – those providing services to the plan
    • Any business entity i.e., LLC, Corp, Trust or Partnership in which any of the disqualified persons mentioned above has a 50% or greater interest.
  • You likely won’t get any advice from the custodian on the tax implications, investment soundness, or legality of any moves you make.  Make sure you know what you’re doing or that you’ve hired a team who can give you good advice!
  • Variable costs.  I’ve not seen many published values, but Clint Coons suggests setup fees run $1500-$2000 and $300-$700 annually.  Depending on your asset base, a self-direct IRA will likely cost more than typical IRAs that limit your investment options to stocks and bonds.

 

What am I planning to do?

For now I’m focusing on more traditional approaches:

  1. I don’t have enough cash in my non-401(k) retirement accounts to justify the transaction costs of a self-directed IRA…and I’m not quite ready to quit my day job!
  2. I still believe in diversification, and real estate makes up a slightly out sized portion of our total net worth.