You’ve heard that money doesn’t buy happiness. That’s true. What savings buys you is freedom and security. Those are priceless, but only if you value them. If freedom and security are important to you, consider how you can achieve them. Think of saving as a state of mind, and realize you are not alone in dealing with this concept.

I have great difficulty saving anything. Am I unusual? 

No, you’re not. Consider whether you identify with any of these examples:

You’ve been hit by an ugly sequence of badly timed financial catastrophes, none of which is your making and many of which were not foreseeable. Everyone gets handed a disproportionate amount of grief at times in their lives.

You’re a serial procrastinator, repeatedly telling yourself there’s always tomorrow to begin anything, including losing weight and dealing with financial stuff.

You have little or no idea how you spend your income. The idea of a financial plan or budget is unthinkable.

You buy stuff because you “just want it”, it’s convenient, it makes you feel good, it’s “discounted” or a “limited time offer”. And you have little or no idea as to whether you can really afford it.

You have no emergency fund for unanticipated expenses, but you do have considerable credit card debt and a new car that was financed with a 7-year payment contract. And perhaps significant student loan debt that may take a good chunk of your adult life to pay off.

You’ve embraced the belief that personal debt is not only acceptable, it’s the only way to afford the life you want, or at least think you want.

You rationalize your lack of saving and your acceptance of debt by believing you will work until age 75 or longer to make up for it. But the reality is you have no idea the medical problems people begin having when they arrive in the 65-70-year-old age category. Talk to family members of that age and they will enlighten you.

OK – fine, I want to do better, but I’m tired of reading about silly “solutions” for saving money – I want something that will work for me. 

Fair enough. Let’s start with your view of yourself, list some situations to avoid, and then give you some practical applications to get you started.

How high a value do you put on your own life and future? The higher the value, and the more hope you have for your future, the more you should be willing to trade some indulgences now for others later. Think of saving as making deposits on your future rather than money you “put away”.

Can you afford to save? The easiest way to answer this is to take a month or two and track everything you spend money on. For most of us, the results are sobering. If there is anything left over that’s good. If not, then go over the list and determine if there is anything you can cut back on. If not, then your only alternative is to increase your income by getting a second part-time job or get a better paying full-time job.

If you want to take a more comprehensive approach, consider creating a budget.

Avoid counter-productive behaviors and people who are intent on separating you from your money.

When you have financial decisions to make, don’t make them when you’re distracted or emotionally vulnerable. Possible distractions are shopping malls, car dealerships, expensive restaurants and bars, emotional disagreements with significant others in your life, and online offers.

Spend some quiet time thinking about what you really value, and then look over your last twelve months’ credit card charges and ask yourself how well they match up. Prepare to be shocked.

Don’t be swayed by people whose job is to separate you from your money. They’re better at their jobs than you are as a consumer; these people are not your friends:

Car dealers. By starting with how much you can afford to pay a month they’ve already framed the discussion on their terms. Do you really think buying a new car is a reasonable financial decision when in 2-3 years’ time it’s already depreciated 35%? Would you buy a $300,000 house with the expectation it will be worth $195,000 in three years?

Realtors. “Buy the most expensive house you can afford, or one even more expensive since you’ll grow into it, and it will appreciate as they always have in the past”.  If you believe residential housing is an investment rather than a place to live, think again, and do some reading about the financial crash in 2008 and what happened to housing prices.

Be creative and find practical ways to make saving as easy and painless as possible.

Channel money from paychecks before you’re tempted to spend it. A 401(k) is a perfect example as you don’t “touch” the money that is skimmed off the top. If you don’t have a 401(k), but you do have electronic salary deposits, divert a percentage off the top to a savings account.

If you get a percentage raise, take a portion of that and divert it to savings. Small amounts are meaningful as they add up over time with the magic of compounding. Once you establish the habit of saving it will serve you well throughout your life. By saving you’re really paying yourself – aren’t you a better investment than a credit card company?

Don’t try to do too much too soon by setting goals for yourself that are unlikely to be met.

When setting goals, think specific, general, short term, and long term. “I want to start saving for retirement” is a non-specific, long term goal. “I want to save $500 by June 1” is a specific, short term goal.

Goals should be attainable, and should be aligned with your values, not taken from some outside source.

Don’t beat yourself up for setbacks that may occur.

Rather, consider setting up rewards for yourself along the way, like splitting savings into two categories: long term, not to be touched until a clearly defined date (like a desired retirement date), and short term, for occasional indulgences when you feel you deserve a reward for being conscientious.

Share both your goals and your successes with people who support the idea of saving – friends, family members, or financial advisers. You are the best person to devise a way to make this work for you, so make smart decisions and be willing to change your approach along the way if needed.

And finally, here’s a personal view based on years of life experiences. If you’ve ever tried to lose weight by going on a diet, statistically you are highly likely to fail in the long run. Why? Because you’ve only modified short term behaviors and inevitably reverted to older long term established behaviors. Saving is no different. Both require that you find ways to make changes in attitude that you can maintain throughout your life.

So try working on your attitude, both short and long term – everything else will follow from that. 

The post How to Save for Anything appeared first on Thoughts On Mastering The Three Phases of Life.

401(k) plans

A 401(k) plan allows an employee to choose between receiving compensation in cash or putting some of this cash into a company-sponsored 401(k) plan. Money that is put into the plan is not taxed until it is withdrawn from the plan. Funds contributed to the plan reduce your federal and state taxes as those contributions are subtracted from gross income when filing tax returns.

For example, if you contribute $1,000 and your federal marginal tax rate is 25% and your state tax rate is 5%, you will reduce your federal taxes by $250 and your state taxes by $50.

If you have the option of contributing to such a plan, should you do it? Generally, the answer is yes, but you need to do a little research first.

Your federal taxes

Are you likely to owe any federal taxes based on your income? The 2026 standard deduction for individuals is $16,500. Do a quick search on “2026 income tax brackets”, determine which bracket you fall in, and deduct the standard deduction. If you are not likely to owe federal taxes, then a 401(k) which allows you to defer taxes is not very useful for you from the perspective of saving federal taxes.

Vesting periods

What is the vesting period? A vesting period is the amount of time an employer mandates that you must work for the company before you can leave with the funds your employer has contributed as a match. The shorter the time, the better.

Note the distinction here – you never lose the funds you have contributed, but the vesting period may restrict when you can leave with funds your employer has contributed.

Company matches

Is there a company match, and how exactly is it computed? A match is when your employer contributes a certain amount to your retirement savings plan based on the amount of your own annual contribution.

Employers usually choose between two approaches: 1) match a percentage of employee contributions up to a specified dollar amount of total salary, or 2) directly match employee contributions – dollar for dollar – up to a specified dollar amount of total salary. The most common match, according to Vanguard’s 2018 How America Saves report, is 50% of every dollar an employee contributes, up to 6% of salary.

It’s important you understand how this is computed because you may wish to contribute only a portion of your salary up to the point where the employer contribution stops, and then use any additional funds you may have to invest somewhere else where you have more options to choose from.

Investment options

What are your investment options under these plans? They are likely to be mutual funds, and these options vary greatly from one plan to another in both numbers of choices and in quality of those choices. If you don’t know how to evaluate the investment options available to you, consider consulting a competent professional How to Choose and Work With a Financial Adviser to analyze them for you and to make objective recommendations.

The average 401(k) plan includes 8-12 investment options, most commonly mutual funds.

Plan fees

What are the plan fees – administrator fees, investment fees, commissions, loads and sales charges, 12b-1 fees, etc.? You can find some of this information in your 401(k) plan’s summary description, and you want to know what they are before you sign up. You can also ask for a prospectus for any funds you are considering or all of the funds the plan offers.

You also want to know how these fees are paid – are they deducted from investment returns, paid by the employer, or deducted from the plan’s assets? According to 401(k) analytics firm BrightScope, fees range from a low of 0.20% to 5.0%.

Your future work plans

What if you expect to work for only a short time, or have no idea how long you might work, with your new employer, should you still consider a 401(k) plan provided the vesting period starts immediately?

Short answer: yes, because when you leave you have the option of rolling over your contributions from a 401(k) to an IRA by doing a trustee-to-trustee transfer that does not result in any taxes being due. You don’t “lose” your money or have it taxed if you meet the IRS guidelines when moving funds.

Before you decide to do a rollover, compare the investment options and fees from your existing plan with your new employer’s plan; it may or may not make sense to do a rollover.

Borrowing options

Can you borrow (borrow, not withdraw) some of your own money from your 401(k)? Yes, if your plan allows it, but don’t do it because the loss in future retirement income is likely to be substantial, and you may never repay it even with the best of intentions which will result in significant taxes and penalties being assessed by the IRS.

If you decide to borrow anyway, ask yourself if you are using the loan to live beyond your means, and make sure you have a realistic plan to avoid default.

Plan flexibility

Can you move a portion of your 401(k) balance to an IRA while you’re still working for your employer? Yes, provided your employer supports in-service distributions. If your employer offers funds that do not meet your investment objectives you might want to consider an in-service distribution. Before you do however, make sure you discuss it with a tax advisor or financial planner as the rules can be tricky.

If your employer allows in-plan conversions, you may be able to convert assets in your 401(k) to a Roth 401(k). See How to Choose Between Traditional 401(k)s and Roth 401(k)s. Once again, consult a tax advisor before proceeding.

Is participation in a 401(k) plan enough to assure you a comfortable retirement?

If you do participate in a 401(k) plan, should you rely on that plus hoped-for future Social Security benefits as your only financial assets to assure a comfortable retirement? Maybe, if you have well above average earnings over a long period of time contributing to the 401(k), and you were born before 1960. Beginning in 1960 the age for Social Security full benefits begins rising from 65 to 67.

If you do not expect to meet both of these criteria, contributing to 401(k)s is still a good idea, but it is not the whole answer to achieving a comfortable retirement.

The post Should You Participate in a 401(k) Plan? appeared first on Thoughts On Mastering The Three Phases of Life.

Before you entertain the idea of investing any money, you need to make sure the rest of your financial life is in order. Here’s how to do that.

Don’t even think about investing any money in the stock market or anywhere else until you do this.

Invest in yourself first – your “human capital”. If you need to improve your job skills by taking a course, set aside money to allow for that. You have complete control over investing in yourself, and you will never have that control over investing anywhere else. You can also make extra money apart from a regular job by developing a second or related set of skills.

Participate in your company’s 401(k) plan if you have that option Should You Participate in a 401(k) Plan?

Establish an emergency fund for yourself. Think about what your biggest exposure is and set aside money to cover it. For example – an unanticipated car repair bill or an unanticipated vet bill. Don’t be like the large minority of Americans who cannot meet an unexpected $400 expense without borrowing it from friends or charging it to a credit card knowing they cannot pay the bill in the next billing cycle.

Understand the difference between good debt and bad debt. Good debt is money owed on an asset that is likely to appreciate such as a house bought at a fair price. Bad debt is money owed on credit cards or money owed on assets that depreciate such as a car.

Pay off all credit card debt but do not be in a rush to pay off your student loans.

Pay off outstanding balances on car loans. That is “bad” debt, tied to an asset that depreciates in value. And depreciates significantly in the first 3 years.

Assuming you’ve met all of the above – congratulations for a great beginning. Now:

If you are highly risk averse – you don’t sleep well at night watching your investments rise and decline, you should think carefully about investing in stocks or any other vehicle that is subject to increases and decreases in value.

If you have difficulty separating emotions from objective financial decisions, you should acknowledge this and ask yourself how that might affect your future behavior making good investment choices.

Be able to explain in one sentence why you bought or are thinking of buying a particular stock, bond, mutual fund, etc., and be able to explain before you buy it what would have to happen for you to consider selling it.

Read everything, be skeptical of everything, and watch out for hidden agendas. It takes time and effort to learn how to eliminate the “noise” found on the television, in books and articles, and on the Internet.

Never act on a “hot tip”, regardless of the source.

Understand the difference between speculating and investing. If you don’t know the difference, you’re already in trouble. Go back to “Read everything”.

Take a look at Why You Need an Investment Policy Statement (IPS) For Investments. And then be able to define your investment objectives and your risk tolerance.

Start small and build on successes.

Consider whether you want or need professional help:  How to Choose and Work With a Financial Adviser.

The post I’ve Got Money to Invest – Should I? appeared first on Thoughts On Mastering The Three Phases of Life.

Money is more than a medium of exchange

Money intersects our lives on a constant basis and challenges us to make decisions in our best interests. These decisions affect not only ourselves but people around us including family, friends, and organizations with whom we elect to do business.

We all hate to talk about money. Why? Because it can result in a jumble of emotions that include guilt, shame, fear, and anger.

Money reflects values. Budgets, credit card and checking account statements reveal our conscious priorities and give us clues as to our unconscious motivations. And these records sometimes conflict with what we proclaim to be our true values.

Wealth is frequently confused with money. Wealth is a state of mind in which money plays only one role. Confusing these two concepts can lead to a life of unhappiness and dissatisfaction.

What money means to you personally

What does money have to do with who you are? Why is money important to you? Note this focuses on how you feel about money, not what you know about it.

Do you feel that dealing with money intrudes on the real purpose of your life?

As a child, what did your parents teach you or say to you about money? Were there differences between your father and mother when it came to feelings and ideas about money? Did they even talk about money?

What is your most painful and most joyful money memory? How did these experiences influence your feelings about money? Do you continue to make choices based on these earlier experiences?

When you purchase something do you experience gratitude or are you resentful that you might have paid too much, that you might have been taken, or that you’re a victim of financial forces beyond your control? What does your answer to this suggest?

What is your greatest financial fear, and to what extent does that influence your attitudes towards money?

Does taking a few minutes to reflect on these questions change anything about how you have dealt with money in the past?

What, and who, do you want your money to serve?

Family, friends, charities, education, spiritual needs? How well aligned are your goals and values with your financial circumstances?

If you were told today you had a limited time to live would you make any changes based on your goals and values? If so, why not make them today?

What, if anything, are you willing to do differently in the future when it comes to dealing with money?

The post What Does Money Really Mean To You? appeared first on Thoughts On Mastering The Three Phases of Life.

Cash on hand. Some call this an “emergency fund” which I believe is badly named and not a helpful characterization. Here’s what you really need to know: Do you have enough cash on hand to cover your biggest exposure? If you don’t know what your biggest exposure is, take a few minutes and think about it.

If it’s an unexpected car repair, that’s one thing. If you work in an industry where there are frequent layoffs, and it’s possible (or even likely) you may one day find yourself jobless for 6 months, that’s a very different thing.

Be both practical and realistic when assessing your exposures.

Savings. Ignore everything you have ever read about this. If you’re saving anything on a regular basis, you’re off to a good start. Remember to take credit for everything here, including things like employer matches.

Think of savings as a way of life, not some edict handed down by personal finance “experts”.

Housing/lodging costs. Include in this all related expenses. For example, if you own a house, include principal payments, interest payments, property taxes, and homeowner’s insurance. Note annual maintenance costs get piled on top of all of that.

If these costs total 28% or less of your gross income you’re doing fine, meaning you are likely to have money “left over” to cover other expenses. The higher this percentage rises, the more likely you will fall into the “house poor” category. Recent increases in housing prices have made this more and more difficult.

Debt payments and income. Add up all your recurring monthly payments: housing/renting, student loans, car loans, and credit card payments, and divide the total by your monthly after-tax income. This is your total debt to income ratio.

If it’s 36% or below, you’re doing fine. If it’s higher, you’re at risk for sinking deeper and deeper into debt as a way of life, and increasing the probability lenders will either refuse to lend you money in the future, or they may do so but only at significantly higher interest rates. Keep in mind that future borrowing at higher rates of interest contribute to the possibility of continuing to sink deeper into debt.

Net worth. Add up the market value of everything you own (your assets) and subtract all your outstanding debts (accountants call these liabilities). If you own an auto that has a market value of $10,000 but also has a loan balance of $8,000, the car counts as a $2,000 asset. And don’t forget to include household furnishings, savings accounts, 401K accounts, and investments if you have any. You want your net worth to grow over your lifetime, starting small when you are in your twenties and growing to an amount that will enable you to retire at your choice of retirement age later.

Bottom line – if you don’t know where you are and how you got there, it’s difficult to figure out where you’re going.

The post Your Financial Health appeared first on Thoughts On Mastering The Three Phases of Life.

Question 1

Mary and Dick file a joint tax return every year. Dick likes to have federal taxes over withheld so that they get a refund every year which is usually around $1000. Mary, who is more financially savvy than her husband, suggests that they adjust their withholding allowances, take that $1000, and invest it every year where she believes she can get a conservative 6% annual return over 20 years. If Mary succeeds in convincing him, about how much money would they have at the end of 20 years:

1. about $25,000
2. about $30,000
3. about $35,000
4. more than $35,000.

If they invested the $1000 once a year at 6% they would have $36,785.59 at the end of 20 years compared to Dick’s approach which results in $20,000. They would have a gain of $16,785.59.

Adjusting withholding to break even with the IRS can be a good strategy, otherwise you’re letting the IRS use your money all year long at your expense. 

Question 2

Nancy, aged 35 and single with a 10-year-old daughter, has her own housecleaning business with herself as the only employee. She has just bought a house with a $200,000 mortgage and has purchased a $200,000 life insurance policy for herself. Her thinking was to protect her daughter’s future by covering the balance of the mortgage should she die prematurely. Which of these is the best answer:

1. Purchasing life insurance was smart to protect her daughter’s future.
2. Purchasing life insurance at the age of 35 is throwing money away to insure against a very low probability risk.
3. Purchasing insurance was a good idea, but she should have put a higher priority on disability insurance.
4. Nancy doesn’t need any type of insurance other than health insurance for her and her daughter.

A typical female, age 35, 5’4″, 125 pounds, non-smoker, who works mostly an office job, with some outdoor physical responsibilities, and who leads a healthy lifestyle, has a 24% chance of becoming disabled for 3 months or longer during her working career with a 38% chance that the disability would last 5 years or longer. A 35-year-old-woman has a 12% chance of dying before reaching age 65. Since Nancy does not have any backup, if she cannot work she loses both her income and possibly her business. She needs health insurance and she should consider disability insurance before any other types of insurance.

When considering insurance, make sure you’re clear on the risk you’re insuring against.

Question 3

Jeff, aged 40 and single, made a good financial decision when he opened a Roth IRA account 10 years ago which now has a balance of $50,000. Of the $50,000 he contributed $40,000 over 5 years with the other $10,000 coming from appreciation of the investments in his account. Now approaching a mid-life crisis, he has decided he’d rather have a new sports car than a Roth account. Which of the following is true?

1. Jeff cannot withdraw any of this money because he is not aged 59 ½, a rule dictated by the IRS.
2. He can withdraw the entire $50,000 and not pay an IRS penalty.
3. He can withdraw some of the $50,000 and not pay an IRS penalty.
4. There is not enough information to answer this question.

Jeff can withdraw $40,000 without penalty. Contributions can be withdrawn at any time from Roth IRAs, but appreciation on those contributions is subject to penalties unless specific requirements are met. Buying a new car at age 40 does not meet any of the IRS rules for exceptions.

Try to avoid a mid-life crisis.

Question 4

Jennifer, aged 25, has graduated from college and has had the good fortune to find a fulltime job with a company that offers a 401(k) plan. Her company will match, dollar for dollar, up to 3% of her annual salary which is $30,000. She decides not to participate in the company’s 401(k) plan because she doesn’t think she’ll be working there for more than a few years. But she does plan on putting 3% of her yearly salary into a mutual fund in a taxable account she plans to open, with deposits made monthly. Assuming a 6% investment return for the 401(k) plan as well as for her newly-opened taxable fund, about how much is she foregoing if she stays at her job 5 years and doesn’t enroll in the company’s plan?

1. Not very much, and that justifies not enrolling in the 401(k) plan.
2. $4,500.00
3. $4,635.35
4. There is not enough information to answer this question.

Answer “3” would be correct except for two things: it does not take into account any salary increases Jennifer might get over that 5-year period, and it ignores the taxes she would save by enrolling in a tax-deferred plan such as a 401(k). Taking both into account, the amount she is foregoing would exceed answer “3” by an undetermined amount. There is not enough information to answer the question.

Don’t ignore a company’s 401(k) plan just because you’re young.

Question 5

George’s investment portfolio ran head first into a stock market crash, resulting in his investments losing 50% of their value. What percentage increase must his portfolio subsequently regain to be back to where it was prior to the crash?

1. 50%
2. 75%
3. 100%
4. 150%
5. 200%

If George loses 50% of a $10,000 portfolio, he loses $5,000. To recover this $5,000, he needs a subsequent gain of 100%.

This is a good example never to forget as there have been 50% and worse crashes in the history of the US stock market. If your investments are 100% in stocks you should either be prepared to endure substantial losses at some point, or you should better diversify your investments by adding bonds or other appropriate investment vehicles.

Question 6

Ron is computing the 5-year return on his portfolio. In the first year he got a 10% return, followed by 20%, minus 20%, minus 10%, and 0%. He computes his average return as 0 for that 5-year period. But when he looks at his latest broker statement, his current balance is less than it was 5 years ago; he is down about 5%. The reason is:

1. Ron is getting unreliable account balances from his broker.
2. Ron is math challenged.
3. The broker has subtracted a 1% asset management fee every year.
4. Ron computed an arithmetic mean when he should have computed a geometric mean.

Ron is not math challenged but he is however making a common mistake. While his average return is 0 just as he computed he needs to compute the actual return this way: 110% times 120% times 80% times 90% times 100%. This can be rewritten as 1.1 X 1.2 X .8 X .9 X 1.0 = .9504. If one or more of the returns is negative, then a geometric mean will always be lower than the arithmetic mean. Mutual funds report their 3, 5, and 10-year performance results using arithmetic means – it’s hardly surprising as to why they do so.

Don’t be mislead by statements made in the financial media.

Question 7

Susan loves new cars. She’s thinking of buying a new car for $50,000. She does her research, checks Edmund’s, and discovers that cars depreciate on average 19% after one year, 31% after two years, 42% after 3 years, 51% after 4 years, and 60% after 5 years, meaning her new $50,000 car would be worth about $20,000 after 5 years. The used car she’s looking at is 3 years old and costs $29,000. She plans on keeping her next car about 3 years before turning it in and wants to keep her monthly payments down by taking out a 60-month loan. She can get an interest rate of 3.54% on a new car 60-month loan, and an interest rate of 4.14% on a used car 60-month loan. Assuming she does trade 3 years later, which is the better choice for Susan right now?

1. The new car because the interest rate is lower.
2. The new car because the trade in value will be higher after 3 years have elapsed.
3. There will not be an appreciable difference in her cost since she plans to trade the car in 3 years.
4. The used car, as she will be better off by over $10,000 when she trades it compared to the new car.
5. There is not enough information to answer this question.

The new car will be worth $29,000 after 3 years, she will have paid the bank $32,793.48, and she will still owe the bank $21,072.06, the remaining balance on her loan. She now has a $29,000 asset which has cost her $53,865.54.

The used car will be worth $20,000 after 3 years, she will have paid the bank $19,292.76, and she will still owe the bank $12,323.45, the remaining balance on her loan. She now has a $20,000 asset which has cost her $31,616.21.

After 3 years the used car will be worth $9,000 less than the new one, but it will have cost her $22,249.33 less, so she is better off buying the used car by $13,249.33. Buying the new car will cost her about $368 more per month than the used one ($13,249.33/36).

Financing a depreciating asset should be avoided if possible. But if you must, find a way to think about your options carefully before visiting a car dealership.

Question 8

John, aged 30, is planning to retire in 30 years at age 60. He says he cannot afford to begin setting aside money now, so he plans to fund his retirement savings by setting aside money in his 50s when he expects to be making a lot more money and can therefore afford to save a lot more money. Assuming he wants to have $500,000 in his retirement savings at age 60, and assuming he can get a 6% annual return on his investments, how much more will he have to save every month in his 50s than if he had started 20 years earlier at age 30?

1. about $497 per month
2. about $1,000 per month
3. about $1,500 per month
4. about $2,000 per month
5. over $2,500 per month

To reach John’s $500,000 goal assuming a 6% annual return requires a monthly contribution of $497.75 for 30 years. To reach the same goal in 10 years requires a monthly contribution of $3,051.02. He would have to save about $2,553 more per month if he delays putting money aside until he reaches age 50. Einstein is sometimes credited with characterizing “compounding” as the eighth wonder of the world.

It pays to start early.

Question 9

Sarah is justly proud of herself for having saved $20,000 by the age of 30. A friend of hers recommends that she take this amount to a financial planner she knows who will invest Sarah’s $20K and manage it for her. She agrees and is told by this planner that he will be happy to assist her, will charge her a fee of 1% per year on the total of her investments, and will invest her money in 5 or so stock mutual funds that are diversified. She agrees. The adviser then picks 5 mutual funds each of which is a load fund, meaning 5% of her $20,000 is taken right off the top and shared as fees between the adviser and the 5 fund companies. Note this is on top of the annual 1% asset management fee. How should Sarah feel about this?

1. She should be fine with this as the fees are reasonable and won’t make much difference over time. And she’s optimistic that her adviser is likely to beat the market in both the short and long terms.
2. She should find another adviser as she has already lost an amount money that will make a very large difference over her investing lifetime.
3. She should do a bit of research on no-load, low cost stock index mutual funds and make her own investment decisions.
4. She should find a fee-only financial planner who acts as a fiduciary, and who has a demonstrated track record of making good investment recommendations to clients. Spend an hour with this person, and then decide how she wants to proceed.

If she sticks with her current adviser she will have $66,227 after 30 years. This is after taking out ongoing adviser fees, the 5% upfront load, and assumes 0.75% annual mutual fund fees. It does not account for yearly taxes that need to be paid from the mutual fund taxable distributions.

If she instead puts the original $20,000 in a low cost no-load index fund like the Vanguard 500 Index Fund, she will have $113,577 after 30 years; a gain of $47,350 or $1,578 every year. This result is after taking out the 0.04% Vanguard mutual fund fee. Like the other example, it does not account for yearly taxes that need to be paid from the mutual fund taxable distributions. However, since this is an index fund with low turnover, these taxes will almost certainly be less than the taxable income generated by actively managed funds due to their high turnover caused by frequent buying and selling.

If she had started with $100,000 instead of $20,000, she would have $331,135 and $567,883, respectively, after 30 years. The difference, $236,747, is because of the fees paid and the compounding effect of paying them over time. And contrary to what you might have heard (see answer “1”), the odds of any adviser beating the market over long periods of time are virtually zero.

Costs matter, a lot. Please choose answer “4”.

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What is a Fiduciary?

A fiduciary is an investment professional who is legally required to act in a client’s best interest. An example is a state Registered Investment Adviser (RIA) who is required to act in a client’s best interest at all times. Broker-dealers are required to act in a client’s best interest at the time of recommendation. This distinction is not obvious and is the result of recent regulatory actions described below.

Fiduciaries in practice

A financial professional who acts in a fiduciary capacity:

Makes the effort to thoroughly understand a client’s objectives and risk tolerance, and then uses a documented, objective process for evaluating and recommending appropriate investments.

Discloses before the fact any potential conflicts of interest that could affect his or her ability to serve in a client’s best interests.

You should always ask questions that require full and honest disclosure of potential conflicts of interest. If you are unsure of the status of anyone managing your  money or giving you financial advice, ask if they are doing so as a fiduciary. If they avoid a direct answer, consider that a red flag.

Fiduciary oaths

Here is an example of a fiduciary oath:

I believe in putting a client’s best interests first. Therefore, I commit to the following five fiduciary principles in a document which I will sign upon request for any client:

I will always put your best interests first.

I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional.

I will not mislead you, and I will provide conspicuous, full and fair disclosure of all relevant and important facts.

I will avoid any conflicts of interest.

I will fully disclose and fairly manage, in your favor, any conflicts that are unavoidable.

Fiduciaries and the state of North Carolina

In North Carolina, where I live, fiduciary duties are defined in 18 NCAC 06A.1801 as a:

Duty of care.

Duty of loyalty.

Duty of obedience.

Duty to act in good faith.

Duty of disclosure.

You should choose a fiduciary if:

You want to be assured that your adviser is making recommendations based solely on your best interests.

You want these recommendations to be based on your investment portfolio and how that integrates into your total financial circumstances.

You are willing to pay your adviser directly for his or her services.

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1) $1,000,000 deposited in your bank today, or

2) $5,000 deposited every month in your bank for the rest of your life, guaranteed.

Your choice reveals a great deal about your attitudes towards money in general, and your ability and willingness to take risks. This has relevant implications for saving, spending, and investing. Take a few minutes and reflect on that.

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Maybe, but probably not. Don’t be swayed by people who tell you it’s a great idea since you’re simply borrowing your own money and paying yourself interest.

Some factors to consider:

Is borrowing this money earmarked for a good cause?

There’s a big difference between using it for a down payment on a house and taking an expensive vacation. And if you’re thinking you can use it for loan consolidation, how sure are you based on past behaviors that you won’t run up another pile of debts having consolidated and paid off the first pile?

Have you compared all your options for raising money?

Is a personal loan an option? Is waiting until you have saved the amount an option? Is borrowing from family members an option?

Have you weighed the advantages and disadvantages of 401(k) loans?

Advantages include quick approval, the likelihood of a lower interest rate than your other options, a payback period of five years or fewer, and total flexibility as to what you use the funds for.

Disadvantages can be ugly. Leaving your job for any reason requires paying the loan back by the date your next tax return is due; failure to do so means the IRS will treat the loan as a withdrawal, tax you on that amount, and slap a penalty on top of that if you are less than 59 ½ years of age. Ouch.

Perhaps the greatest disadvantage is the loss of the compounding effect for building your savings because the money you withdraw is no longer working for you over extended periods of time.

So, good idea or not?

If you take the loan you are betting that your job situation will not change, that you will have no trouble paying the loan back, and that the loss over time due to missing out on the compounding effect will not be an issue in your future. For many, these should count as show stoppers.

Think carefully, and choose wisely.

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Assume you have money set aside to cover emergencies, and you have money in a savings account as well. Or perhaps you just received some money through an inheritance. Should you use any of these sources to pay off your mortgage or take that money and invest it?

The simple answer

If, in the past, you have had trouble managing your finances, particularly managing debt, then you are probably better off continuing to make mortgage payments. You can see the progress you’re making with these payments by simply looking at your bank statements.

On the other hand, if you have demonstrated in the past that you can successfully manage your finances and you are willing to spend time in the future managing them, then you should consider using the money for investing. While investing can do a better job of building wealth than paying off debt, this is by no means a certainty.

Relevant factors in your decision

General factors to consider are your age, your home’s current market value and anticipated future appreciation, your marginal income tax rate now and your estimated marginal tax rate in retirement, your current mortgage interest rate and terms, and your estimate and confidence of future returns in alternative investments such as stocks and bonds.

Paying down, or paying off, a mortgage, pros and cons

If your mortgage rate of interest is 4%, then your mortgage is costing you 4%  in interest payments providing you do not itemize your deductions for federal tax purposes. If you itemize, your cost is less than 4%; the actual cost will depend on your marginal tax bracket. Note that as a mortgage balance declines or is eliminated, any tax benefits you get with itemizing deductions also decline and are eventually eliminated.

In your retirement years having lower monthly expenses is always good; having a small or zero mortgage payment could be a valuable benefit especially for people who rely heavily on social security payments or who have minimal or no pensions.

Sinking all your money into an illiquid asset – a house – is a big drawback. You probably never thought of your “free and clear” home as having an associated cost, but that’s exactly what it is – the opportunity cost of the money tied up in it. Home equity lines of credit and reverse mortgages can be used to offset this drawback, but they have their own downsides.

A house does not care whether it has a mortgage or not. It exists for people to live in and enjoy. Mentally coupling money tightly with housing can restrict your overall financial options when thinking about strategies appropriate for your total financial circumstances.

Going with investing, pros and cons

Assuming you can capture only half the return of stocks in the last 80 years, that’s half of 10% or 5%; you are still getting a better return on these investments than the 4% you’re getting paying down or paying off the mortgage (ignoring taxes). But that return may fluctuate considerably over time. A more conservative and predictable approach would be to compare the percentage return from a very low risk investment such as a Treasury note or bond with your mortgage rate. When comparing returns always consider the tax effects – taxes potentially reduced from the mortagage interest deduction and taxes potentially owed from investment returns.

Investments such as stocks and bonds are far more liquid than real estate. Asset diversification is improved as you now have investments, real estate, and investments that can be turned easily and quickly into cash when needed.

Unlike your monthly mortgage payment, you will have to monitor the performance of your investments either by yourself or through turning them over to a broker or financial adviser. And these values will fluctuate. You should ask yourself how comfortable you are with that –  How to Gauge Your Tolerance for Investment Risk.

Two different simple but meaningful perspectives for deciding

From an emotional perspective, consider what is most appealing to you, and what you can live with. Decisions based on emotion are not necessarily bad; they merely need to be acknowledged for what they are.

From a practical perspective, consider how easy it is to undo whichever choice you make, as there may come a time when you need to do exactly that. Having options is always good given the difficulty of predicting the future.

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