As we discussed last week, personal finance can be intimidating. But it doesn’t have to be complicated.
In Part I of this two-part series, the White Coat Investor quickly walked us through the personal finance basics from student loans to retirement and delved into some fascinating (#nerdalert) intricacies of tax preparation and business ownership.
Today in Part II, JL Collins brings us back to those basics and explains the Why? behind it all in The Simple Path to Wealth. His book began as a series of letters to his teenage daughter and now shares his wisdom with all of us.
“Spend less than you earn–invest the surplus–avoid debt”
This book is simple without being condescending. It has 257 pages of well-written digestible wisdom with enough stories to keep it entertaining and enough repetition to make the key points stick.
Before you learn how to invest, you need to know your Why.
Do you want to travel more? Have a dozen kids? Buy your parents a house? Collect fancy cars or fancy cats? Start or support a charity? Live by your own rules? Or do you just want options?
Once you have enough savings to keep you afloat for a few months, you won’t be so afraid to lose your job. You can negotiate a little harder or say no to overtime. You can stay at home longer with your newborn, stand up to a terrible boss, or start your own business.
“It’s a big beautiful world out there. Money is a small part of it. But F-You Money buys you the freedom, resources and time to explore it on your own terms.”
Most of the time you’ll keep your job while both your finances and circumstances improve as a result of your strength and efforts, but if not, you’ll still be just fine.
Eliminating debt decreases your mandatory monthly expenses and thus the amount of savings you need to ride out an emergency or major life change. Plus, this money earns income of its own.
Once you have money saved over and above your emergency fund, you’re ready to invest it. However, choosing which stocks to buy can be complicated. Knowing which companies are good investments requires more time and effort to research than most of us have or want to spend on finance.
Even within your own industry, there’s so much you–heck, even the experts and CEOs–don’t know. What if there’s a huge scandal? Enron, anyone? Stock prices can plummet instantly.
So instead of putting all your eggs in one basket, Buy All The Stocks with a total market index fund like VTSAX.*
Why not just buy actively managed mutual funds? Very few of them outperform the market, and after accounting for higher fees and expense ratios, you’ll come out ahead with index funds. Remember that the products being sold the most aggressively are the ones with the highest commissions, not necessarily the ones that are best for you.
“The more complex an investment is, the less likely it is to be profitable. Index funds outperform actively managed funds in large part simply because actively managed funds require expensive active managers. Not only are they prone to making investing mistakes, their fees are a continual performance drag on the portfolio.”
Consider adding bond index funds like VBTLX to smooth out the ride, and increase this portion of your portfolio when you retire.
Like WCI, Collins doesn’t recommend using a financial advisor because by the time you know enough about finance to find a good one, you won’t need one.
With Collins’s super-simple portfolio, DIY is simple and advisors can literally cost you millions in commissions, assets under management fees, and hourly fees.
But, if you know yourself well and know you won’t save or invest without someone holding you accountable, then an advisor is worth every cent.
Don’t believe advisors who tell you they can time the market.
Even with index funds, the market will rise and it will fall. There will be crashes over your lifetime, but overall the market will rise. Hold on tight and don’t eject yourself from the ride–you only lose in a down market if you sell before the market recovers.
“It is simply not possible to time the market, regardless of all the heavily credentialed gurus on CNBC and the like who claim they can.”
Keep in mind that even if you sold your entire life’s savings after a crash, you wouldn’t lose as much as you think because you didn’t buy all your investments at the market peak. In fact, if you had been investing for a few years, you probably still made money because you bought into the market for even less than post-crash prices.
While your money is growing, protect it from the IRS as much as legally possible.
Collins discusses how to strategically fund taxable, tax-deferred, and post-tax accounts. In a nutshell, tax-efficient investments that pay qualified dividends (low tax rate) are fine for taxable non-retirement accounts.
Tax-inefficient investments like bonds, CDs, and REITs are better in retirement accounts where their interest, capital gains, and non-qualified dividends are either not taxed at all or not taxed until withdrawal many years later and where the tax rate is equal for qualified and non-qualified dividends.
He also explains withdrawal strategies to minimize taxes.
After age 59 1/2, withdrawing from a retirement account is penalty-free. Exact numbers change every year, but for 2016 a married couple can earn up to $96K before jumping from the 15% to the 25% tax bracket. If RMDs after age 70 would push them to a higher bracket, they can use a workaround to lower their future RMDs.
For example, if they earn $50K from employment, they can also pull $46K from a pretax retirement account, pay the 15% tax, and roll the $46k into a Roth where it will grow tax-free and not be subject to taxes later. This lowers the balance in the pretax account, so RMDs will be lower when they turn 70.
If this all sounds like gibberish, don’t worry. After reading the book it will be crystal clear.
Health Savings Accounts
HSAs are another place to save on taxes. Money is invested pre-tax and grows tax-free until you need it. If you spend it on medical expenses, you’ll never pay taxes on it. You can even let it grow for years while you save your receipts, then withdraw the amount of those medical expenses tax-free later.
If you’re age 65 or older, you can withdraw the money for any purpose–not just medical expenses–penalty free, though you will have to pay taxes. This is why the HSA is often called a stealth-IRA. If you think your tax bracket in retirement will be lower than your current bracket, take advantage of the tax-deferred growth and savings.
Great Job! Now What?
You’ve lived below your means, invested wisely, and saved for retirement. Now what?
Collins discusses the research behind the 4% rule, which states that you can spend up to 4% of your assets every year and not run out of money in 30 years. Most of the time your assets will even continue to grow and your heirs will end up with more than you started retirement with!
There are various strategies for withdrawing money from your accounts, and the amount you need will depend on your income from social security and other sources. Chapters 29-31 offer priceless advice on these topics.
Chapter 32 details how and why to start a charitable foundation rather than giving directly to individual charities, but the key message is to decide where and how you want your money to have an impact. If you want bang for your buck in terms of happiness, you’ll get much more from giving than from buying.
This is a book you’ll read, re-read, and give to all your friends and family. It’s never too late, but the sooner you start living by these principles, the better off you’ll be in retirement.
Have you read this book or do you recommend another personal finance gem? Which topics would you like to know more about? Let me know in the comments below.
*You’ll quickly notice that Collins is a die-hard superfan of Vanguard. Jack Bogle, the inspiration for Bogleheads (another excellent book), founded Vanguard in the 1970s and made the first index fund available to the general public. Vanguard is client-owned, so it doesn’t have private shareholders and this helps keep costs low. Collins also argues that VTSAX includes international companies, so buying an international fund is redundant and more expensive.
Fidelity, Schwab, and other companies also offer index funds with very low expense ratios, so do your research and make your own choices.
I am not a financial planner, and this is only a book review. Invest at your own risk.
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