Chapter 22
Case study: Putting The Simple Path
to Wealth into action
So far we’ve discussed concepts and strategies to create your own simple path to wealth. For those few of you reading who are just starting out, this should be perfectly easy to implement. But most of you are already somewhere along your path. Perhaps you’ve made some mistakes and hold some investments you wish you had never made. Perhaps you hold too many different assets and realize now it doesn’t have to be that complex.
Regardless, you already have things in place that need to be considered.
How, you might be asking, can I implement these ideas in the real world?
Clearly, I have no way of answering that for each reader who picks up this book. But in this chapter, I’ll share with you a real-life reader case study drawn from www.jlcollinsnh.com.
For the purposes of this chapter, I’ve taken the liberty of consolidating this reader’s questions and situation, and have done some editing for clarity.
Other than that, where he is quoted all the words are his.
His note:
“I’m 26 and have recently graduated from college, and decided to get my financial life in order. Luckily, I was able to find a great job and have no debt. I am working on saving up my emergency fund (roughly 24% of my income is going into it) and now I’m focusing my efforts on investments.
“My grandparents seeded an investment fund for all of their grandchildren when each was born. It has been managed by a financial advisor for years, and your posts have confirmed my thoughts that I can do better. It currently has around $35,000 in it in 12 different mutual funds.
“My grandmother doesn’t remember the exact amount that started my account. Whenever a new grandchild was born, she would put in a starting amount equal to what was in the older children’s accounts. The earliest record is from 1994. At the start of that year, there was approximately $6,700 in the account and $1,000 was added by my grandparents each year until it hit around $25,000. In 1994, the funds were half stocks and half bonds (my grandfather grew up during the Great Depression and didn’t fully trust stocks).
“My employer offers a 403(b) plan and they match contributions up to 2.5%. Currently, I put 3% of my income into this. Vanguard’s Total Stock Market Index Fund is one of the available options.
“I make $70,000 per year before taxes. Right now I’m saving 24% of my pay. My goal is to keep it at 20% or more, but realize I might have to drop to 15% if other commitments arise. I haven’t really thought about when I want to retire. It would be great to retire early, but I have not officially set that goal.
“I think I’m also going to do a Roth IRA on my own.
“What is your suggestion on getting rid of my financial manager and all the mutual funds and buying into VTSAX? I don’t fully understand the tax implications that are involved in that. Correct me if I’m wrong, but $5,500 would go into the Roth and the rest into a traditional account. Is it okay to have the investments in my 403(b), Roth IRA, and my regular account in VTSAX?
“What is the best way to contribute to my funds? After I get my emergency fund built up and my money transferred to Vanguard, I will have around $1,000 per month. Do I put that in each month or wait to put in larger amounts. I have heard of dollar cost averaging, but haven’t looked
into it.
“Thanks for your advice and time.”
The beginning of my response was this:
“Before we get started, some congratulations are in order. No, not for you.
For your grandparents!! They deserve big time major league kudos. Please tell them I said so.
“The fact that they have provided this seed capital for you and their other grandchildren tells me several things. They have resources, and that means they are fiscally responsible and effective in their own lives. They are generous. And, considering your questions and plans, clearly they have passed this on to their descendants. If you haven’t already, take them out to dinner and raise a toast in their honor. If you already have, do it again.”
Looking at his situation, we have a great base
upon which to build:
$35,000 in capital to start. $70,000 salary and he is saving 24%, or $16,800 annually.
He wants to target saving about 20% going forward, or $14,000.
As you’ll see, I’ll try to persuade him to increase that.
He’s landed a good job with an employer that provides a 403(b)
retirement plan.
Zero debt.
He’s not sure about retirement yet—no surprise at age 26—but he recognizes the importance of F-You Money.
He wants to know how to contribute to his investments going forward and about dollar cost averaging.
Let’s talk first about what investment to choose.
Fortunately, his employer’s benefits plan offers Vanguard as an option.
He is leaning toward Vanguard’s Total Stock Market Index Fund and that idea is spot on. In fact, this is where we’ll put all of his investments. He is in the wealth accumulation phase of his life and it’s the right tool for the job.
In Chapter 17 we learned there are three options to owning this fund portfolio: Admiral Shares, Investor Shares and VTI, an ETF (Exchange Traded Fund). VTSAX is the Admiral version and provides the lowest cost, but has a $10,000 minimum buy-in. The Investor Shares option, VTSMX, holds the same portfolio, but with slightly higher costs and a $3,000 minimum. He should use Admiral Shares whenever he can and Investor Shares if needed as a start. Once the account reaches $10,000, Vanguard will automatically switch it to the lower-cost Admiral Shares.
As we’ve seen, this one fund gives him a portfolio that owns virtually every publicly traded company in the U.S. Since many of these have extensive international operations, he’ll also have international market exposure. With this one investment he’ll have broad diversification in the most powerful wealth-building asset of all: stocks. This allocation of 100% stocks is considered very aggressive and that’s what we want for this phase.
But be warned, as you know from reading the previous chapters, he can expect a wild and gut-wrenching ride. With that said, he’s going to stick to the plan, keep investing and tough it out. At 26, he has decades ahead.
At some point he’ll start thinking about retirement.
That retirement might not come until he’s 65 or maybe he’ll choose to implement it when he has F-You Money around age 35 or so. Whenever the time comes, as he approaches that phase he’ll want to consider diversifying into bonds. But right now, in the wealth accumulation phase, stocks are where his money belongs and VTSAX is how best to own them.
Next let’s look at the various investment buckets he has available and discuss how to allocate his VTSAX investment among them. You’ll recall that these buckets are where we hold the investments we choose. In order of desirability the buckets are:
1. His 403(b) employer plan.
Since he works for a university he has a 403(b) plan, rather than the 401(k) plans common in private industry. He plans to contribute 3% of his salary which will be tax deferred, and his employer matches 2.5%. That’s free money! That makes this option #1.
2. Deductible IRA.
This is very much like his employer plan in that his contributions to it are deductible and its earnings are tax-deferred. The important advantage, however, is that he has full control over his investment choice and is not limited to those in his plan. He will open his IRA with Vanguard and will choose VTSMX/VTSAX.
Since his 403(b) options are excellent, this matters less in his case. But in many employer-based plans the choices available are not optimal. If you have such a plan, use the guidelines provided in Chapter 19 to find the option that most closely matches a total stock market index fund or an S&P 500 index fund. Most plans have versions of these. Fund it up to the maximum of any company match. Then turn to your personal IRA. Once that’s fully funded, turn again to your employer plan up to the maximum.
Currently, the maximum annual IRA contribution limit is $5,500 and he should try to fund it as close to the limit as possible. The tax advantages are too sweet to leave behind.
3. Back to his 403(b).
Current law allows him to contribute up to $18,000 each year to his 403(b) and at 3% he has only put in $2,100 so far. That leaves $15,900 in potential contributions.
Since he is only planning to save ~20%/$14,000 of his income he should contribute another $6,400 to his 403(b): $2,100 + $5,500 + $6,400 = $14,000. But as I said, we are going to try to persuade him to save more.
Instead he could max out his 403(b) plan by adding $15,900 to the $2,100 he is already contributing for the employer match, for a total of $18,000. Add to this the $5,500 going into his IRA and the total is $23,500.
That’s a saving rate of ~33.57%.
At this point it is worth noting that I am calculating these savings rates based on his pre-tax income. Some would argue that using post-tax income is better as that is what he actually has available to spend. But taxes are very complex and the post-tax income generated from any specific pre-tax income is likely to vary widely. Using pre-tax is just simpler and, because it tends to encourage saving greater dollar amounts, it is more in keeping with the ethic of this book.
For anyone serious about achieving financial independence, taking full advantage of all your tax-deferred opportunities is a must. And doing so starts to get you into a respectable saving rate. But there is no reason to stop here.
4. Ordinary Bucket.
This is where we put regular investments made outside any tax-advantaged buckets. He’ll pay taxes on the dividends and capital gains distributions each year but, unlike tax-advantaged accounts, the money is available anytime with no penalty. This is where his $35,000 spread across multiple mutual funds is now. When he moves it to VTSAX that will still be the case.
Once he sells the 12 funds he currently owns—assuming they have appreciated in value—he’ll owe a capital gains tax. Given this relatively small amount of money and the fact that capital gains taxes are low at the moment, this is nothing to lose sleep over. However, were the amount significantly higher, this decision would become more complex. In such a case, it would require a thoughtful analysis of the investments currently held and their costs balanced against the tax liability.
So here is where we are: His savings rate is currently 24% as he builds an emergency fund, and he plans to reduce this to 20%. Compared to the average American these numbers are excellent. Compared to where he wants to be, he should consider doing more. A 50% savings rate is my suggestion, but others more committed to having F-You Money commonly reach for 70-80%.
He is already stepping out of the norm by being debt free, saving and investing. He is employed, young and childless. Never will he be in a stronger position to take it to the next level. At the very least, he should avoid “lifestyle inflation” by pledging that any salary increases will go towards his investments. If he does this now, in the future his problem will be how to spend all the money his money earns for him.
OK, with all that under our belt let’s run some numbers and look at a couple of options, with their specifics.
Option #1: 24% savings rate
We’ll forget about reducing this to 20% as doing so doesn’t get him where he wants to be.
He starts with the $35,000 from his grandparents and moves it immediately into VTSAX paying the capital gains tax, if any. As we’ve seen the average market return of the past 40 years (January 1975 - January 1 2015) has been ~11.9% annually.At that rate his money doubles about every 6 years. By the time he is 62 (in 36 years) it will have doubled nearly 6 times over. A quick calculation shows he’ll have over $2,000,000, without 3 adding a single penny.By the time he is 68 it will double again to
~$3,900,000. That’s the power of compounding. Did I mention he should take his grandparents to dinner?
If you add to it as you go along, as he’s going to, the results become even more dramatic. Using his current savings rate of 24% he’ll have $16,800 of his $70,000 salary to invest each year.
His 403(b) gets 2.5% of his salary to capture the match, but he’s contributing 3%. That’s $2,100 per year (His employer will add 2.5%— another $1,750—but that’s in addition to his 24%/$16,800 investment money). This will go into VTSAX as his plan offers it. If it did not, the money would go into the choice his plan offered that most closely resembles VTSAX.
His deductible IRA gets $5,500. That goes into VTSMX and this will move to VTSAX once over $10,000.
Between the 403(b) and the IRA we’ve accounted for $7,600 of his $16,800. For the remaining $9,200, we’ll return to the 403(b) and put it there.
Don’t let this three step process confuse you. It is only to walk through the selections in order of attractiveness. Once he’s done that, the actual implementation would be simply:
Fund the 403(b) with $11,300 ($2,100 + $9,200) Fund the IRA to the maximum of $5,500
Option #2: 50% savings rate
Now let’s see what happens if we can persuade him to get a little more serious about saving and investing. Again he starts with the $35,000 from his grandparents, but now we have another $35,000 (50% of $70,000) each year to invest from his salary.
As before his 403(b) plan gets 3% of his $70,000 salary—$2,100—and his employer matches 2.5%.
His deductible IRA investing in VTSMX also still gets the maximum contribution allowed, $5,500.
So between the 403(b) and the IRA we’ve again accounted for $7,600, but now leaving $27,400 to invest. With this we can take full advantage of the 403(b) by contributing $15,900 more. Add this to the $2,100 he contributed to get the match and he’s reached the maximum annual limit of $18,000. And he still has $11,500 left over:
$35,000 - $2,100 - $5,500 - $15,900 = $11,500
We’ll add this $11,500 to VTSAX in the Ordinary Bucket and build on the $35,000 seed capital his grandparents so generously provided.
With option #2 it is not hard to see how much more powerfully his wealth will grow. He is taking full advantage of all the tax-advantaged plans available and is building wealth outside them that he can access anytime without penalty.
Of course, this requires that he organize his life in such a fashion as to live on the remaining $35,000. For some readers this might appear appallingly low; for others, extravagantly high. Either way it is certainly doable. It is simply a matter of choice and priorities and how much he values financial freedom.
Here’s a fun fact: An income of $35,000 puts you in the top .81% of world incomes. Congratulations 1%’er! Want to know where your income puts you? Check it out here: www.globalrichlist.com Finally, let’s talk briefly about how these contributions will happen.
Like most people, he’ll be investing as his money is earned. He’ll be doing this with his 403(b), IRA and any additional money he adds to his ordinary bucket VTSAX account initially funded with the $35,000.
This is in effect a form of dollar cost averaging (DCA); that is investing chunks of money evenly over time. DCA is something we’ll discuss in depth in Chapter 26.
The beauty of his 403(b) account is that once he sets it up, the contributions will happen automatically. The IRA and Ordinary Bucket VTSAX accounts will require him to expend a bit more effort. He’ll either have to remember to add to them regularly—just like paying one’s bills—or he can set them up with Vanguard to have the money automatically transfer.
Automatic’s what I’d do. It is easier and makes it more likely he’ll stay the course.
There you have it. If he follows this simple path, he’ll have F-You Money before he knows it and working will become optional. By the time he reaches his grandparents’ age he will be well able to provide seed money accounts for his own grandkids, continuing the cycle. Around then he might also consider learning “How to give like a billionaire,” which we’ll discuss in Chapter 32.
Note:
If you are interested in the original version of this Case Study, you’ll find it as a post titled The Smoother Path to Wealth on www.jlcollinsnh.com.
You can find several more case studies there, each covering a different and unique situation. Just look under Categories: Case Studies in the right-hand column. For answers to a variety of simpler questions, click the button at the top labeled Ask jlcollinsnh.