Afford Anything - Ask Paula - I Don't Know How to Invest

Episode Date: December 18, 2017

#108: Former financial advisor Joe Saul-Sehy joins me to answer audience questions about investing strategies, early retirement, and tax planning. Whitnee calls in with this: I'm 31, and my husband and I save half of our combined income. We've maxed out our H.S.A. accounts and we're getting an employer match in our 401k. We have $80,000 stashed as cash in a checking or low-yield savings account. We're paying nearly $2,000 per month for insurance policies, most of which is a whole life insurance policy. We have a rental property that cash flows $210 per month; we pocket $150 and use the other $60 as an extra principal payment. What should we do differently? How can we learn about investing? What funds should we focus on? Should we sell our rental property and invest the proceeds, or hold onto this? If we hold, should we focus on repaying the mortgage as quickly as possible? Kim asks about the 4 percent withdrawal rule in early retirement. When you're calculating your savings goal, do you need to account for the tax implications of this withdrawal? Any tips on how to optimize this? Susan says: I loved your explanation about how to use a Roth Conversion Ladder to avoid paying stiff early-withdrawal penalties in retirement. (Episode 94). Here's my follow-up question: How long should my money sit inside of a Traditional IRA before I convert it to a Roth IRA? We tackle these three questions on today's episode. Enjoy! _______________________________________ Resources Mentioned: Whitnee's question: Books: Investing Made Simple by Mike Piper Can I Retire? by Mike Piper The Simple Path to Wealth by JL Collins The Little Book of Common Sense Investing by John Bogle The Wealth Barber by David Chilton The Truth About Money by Ric Edelman Websites: Oblivious Investor by Mike Piper FINRA Broker Check Afford Anything article: I Don't Know How to Start Investing and I'm Afraid of Expensive Mistakes Kim's question: Two articles critiquing the 4 percent withdrawal rule: - https://www.americanfunds.com/ria/insights/can-i-retire-at-40.html?cid=sm_tw_50306 - https://www.cnbc.com/2014/11/03/the-4-retirement-rule-is-broken-and-heres-why.html Susan's question: Episode 94 - The Early Retirement Episode Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. Every decision that you make is a trade-off against something else, and so the questions become twofold. Number one, what is most important to you? And number two, how do you align your day-to-day actions to reflect those priorities? Answering this is a lifetime practice, and that's what this podcast is here to explore. My name is Paula Pan. I'm the host of the Afford Anything podcast. Every other week, I answer questions that come in from you, the listeners.

And this week, my buddy Joe Sal Si-high is joining me. Hey, Joe. I am joining you? You are joining me. That's so fantastic. How are you? I'm excellent. How are you doing? I'm better now that I'm here with you. Awesome. Let's get to our first question, Joe. This question comes from Whitney.

Hi, Paula. My name is Whitney. I've been listening to your podcast for a few months now, and I really hope you can help me out. Here is my financial situation. My husband and I are both 31 years old. We save over half of our combined take-home pay each month. Of that savings, around 2,000 goes towards various life insurance policies, mostly whole life, because that's what the agent recommended. But from listening to previous podcasts, I think we probably have too much in that arena. As far as current investments go, we have a fully funded HSA and could do an employer 401K, though we haven't yet because the employer contributes whether we do or not, and we weren't sure if that was the best investment.

We have a rental by default, meaning we moved and just found a property manager to rent our old house for us. We make around $150 a month after fees and mortgage, though that doesn't include the extra 60. We pay towards principal on that property every month. We have another $2,000 that goes into various savings buckets each month, such as car and home repairs, medical expenses, savings, etc. We currently have around $80,000 just sitting and checking and low-interest savings because I don't know what to do with it. Some of it needs to be liquid in case of an emergency, but most could be invested somewhere until we need it. My questions are many. Where can I go to learn about investing? How do I know if an investment is good or not? Or if a specific fund is good or not? How do we get started if we wanted to do mutual funds? Should we continue stocking money away in whole life policies or would it be better placed somewhere else? Since we will most likely not be doing real estate in a general sense, should we sell the property we have now and use the equity around $30,000 for other investments or is it better to let it float? And if I do let it float, should I continue paying extra each month on it? or not. Is it more important to pay down my mortgages or to do other investments? I just want some

honest advice about the best way to invest my money. I am so tired of financial advisors who don't seem to know anything or who just want me to buy products so that they can get a commission. I guess it comes down to the fact that I don't feel qualified to do this whole investing thing, but everyone that I can ask for advice is selling something and I haven't been able to get unbiased, competent advice that doesn't include a hidden agenda. Please help. Whitney, first of all, congratulations on being in such a good position right now. First, congratulations on saving half of your combined take home pay. That's awesome. Steve, can we get some sound effects, please?

Second of all, let's tackle some of your questions directly. You asked, where can you learn more about investing? Well, hopefully right here on this podcast, but to be a little bit more specific, a few books that I recommend. Number one, anything written by John Bogle. He is the founder of Vanguard. He's written a number of books. J.L. Collins wrote a book, The Simple Path to Wealth. He was also a guest on a previous episode of this podcast. And Mike Piper writes a blog called The Oblivious Investor. Those are some of my favorite resources in terms of initially learning about investing. The broad takeaway, one of the commonalities that I've, that come from all of them, is a focus on a passively managed index fund approach. And fortunately, What's great about that is that it's simple.

A simple, passively managed broad market path is statistically likely to do better over time than one that's very complicated and involves a lot of day trading and hopping in and out of the market. So you actually don't need to know that much about investing in order to be a good investor. In the world of investing, less is more. There's a blog post that I wrote called I'd like to start investing, but I don't know where to begin and I'm afraid of making mistakes. I'll link to that blog post in the show notes, which are available. available at afford anything.com slash episode 108. My frustration with trying to learn about investing is that there's so much to know. And I remember when I first became a financial planner, Paula, I was afraid because I'm advising

other people. I'd already taken a series of licensing exam. So, you know, I knew a lot of basic stuff, probably more than the average bear at that point, but I still didn't feel at all qualified because it's so wide the amount of stuff to know. So I think the best way to do it from my point of view is to do what Stephen Covey says in Seven Habits of Highly Effective People, which is to begin with the end and start off with what your goal is and then what can you save toward that goal? And it sounds like Whitney, you've already thought through a lot of this stuff.

Like, what do I want? And then how much money can I allocate toward that? And then what rate of return will I need? So every goal has this very simple equation. The goal equals an amount of money save times a rate of return, right? That's all that, I mean, if we want to reduce it to this very simple math, well, let's say that to get that early retirement we want, we have to save $4, right? Yeah, right, sure.

But let's say you've got to save $4. Well, let's say you don't have $4. Your budget's really tight and you only have three. That's fine. And what a lot of people do when they don't have $4, you know what they do. they just say, well, I can only save three, so that's what I'm going to do. Without thinking about there's going to be an effect on the other end. And that effect is, I'm either going to have to retire later or I need to raise that other piece

of the equation, which is the aggressiveness of the investment, right? So what's cool is when I go through that equation, it's going to give me a general interest rate that I need. And it's actually not that hard to figure this out. Once you know what interest rate you need, then this huge wide mode of investment. investments to look at goes from being a huge wide mode of investments to being only a few that historically have done what you want to do. And then you can become an expert only in the things you need to know about instead of trying to be an expert in everything. So I like doing

it that way. It makes the process of which investments are right much cleaner. I also had thoughts about this whole life situation that she has. Yes, I have some thoughts about whole life too. But before we get to that, though, Joe, so I think a difference between your approach and mine is that my approach, specifically with regard to market investing or index fund investing, assumes that you will do as well as the broad market overall average. So my approach is you stick with broad market funds, assume that you will get about 8% long-term aggregate returns over time through your equities investments. And then based on that, determine how long it's going to take you to be able to reach your goals. that relationship between timeline and intensity. Joe, your approach is a little bit different in that you recommend actually chasing different modes of returns. So if I'm understanding you correctly, you advocate back calculating, you know, in order to have this amount in my portfolio by why date, I need 12% returns versus 8% versus 6%. And that influences the risk profile of the investment that you go into. Is that your approach? Well, my opinion, and I don't like the word chasing, by the way. So I'm going to back away from that one. But what it does is, you know, there's 19 different asset classes, depending on what, you know, who you talk to.

But generally, there's 19 different asset classes out there. You're talking about probably using something like the total stock market index, which will use three of those, right? Large, medium and small cap stocks. Well, you know, when we look at real estate, there can be CDs. I mean, you could use, you could use a number of things. You could use bonds. and that part of that also depends on the time frame until you need the money. You know, using what you're talking about, large cap stock, I think that's fantastic if you've got 15 years to go. But if you've got four until you want that money, I'd say, why don't you take your money down to the casino? Because if you look at the risk profile of stocks over a four-year time frame, not that wonderful. So different investment classes do well under different conditions and different timeframes. So I want to make sure I know what I want to want to make sure.

I know what I want the money for first, and then I look at historically which investment types have got me there. And then, because I can hear it in her voice that she's so concerned, how do I learn all this about investing? Don't try to learn it all. Just try to learn about that investment that fits the goal. So, Paula, to your point, if you're going to use the total stock market index, I'm looking at 10 to 15 years or further goals for that.

Well, then I learn about the total stock market index because that fits that profile. It's the same with real estate, right? the NERI index over long periods of time and the S&P 500 over long periods of time pretty close to mirror each other. So whether you decide to go with a real estate first portfolio or a stock first portfolio, you know, if it's a long-term investment, you can chase either one of those. Or for better diversification, do some of both. Now, Joe, what do you think about her question? She mentioned that she has a rental property. It cash flows $210 a month, of which $60 she uses as an extra principal.

payment and then she pockets the other one 50 per month. And she asked the question, you know, should she sell that rental and invest the equity, which is worth $30,000 or not? I've got some thoughts on that, but Joe, I'll let you go first. Well, thanks. First of all, I'm not sure what that $60 is based on. I mean, what the whole amount of money is that she has invested and what she's actually bringing in. So I'd like to know more about that. But just generally, if she enjoys the real estate market, if she enjoys owning that property, if she does have the positive cash flow now, I think if she takes that money, depending on how long she has left in the mortgage on that property, and she instead puts it in something that like your total stock market index fund,

to your point, let's say she has 10 years left on that mortgage. I think rather than invest it back into the property, I would take that money and put it into something that will grow more quickly, allowing her to make the decision if she decides to to pay off that mortgage even quicker, which would be that total stock market index. So those are some of my thoughts. So in other words, you would take the cash surplus. You would put it into equities, hold it for about 10 years, and then with the growth of that, you could make a lump sum payment to kill the entire mortgage balance. Correct. And you know what's cool about this, though, Paula? So I used to do this when I was a financial planner. We would set up that very thing. When we would have enough money in

that index fund to pay off the mortgage, guess how many people actually did it? Probably zero or close to. Zero. Because what you're really happy with, what you're really happy with is the fact that you can do it whenever the heck you want to. That's the powerful part, right? If I need to tomorrow, I can do it. But looking at over these little bit longer periods of time, how much faster that grows

than the mortgage pay down. So by putting it elsewhere versus putting it into the mortgage, it grew so much faster. The answer is, well, why would I take that off? I don't need to today. So people would generally, well, not even generally, 100% of people that we did this strategy with always left it in the index fund. Yeah, absolutely. And of course that also, again, it depends on your goal. So if your goal is early retirement and you want to achieve that by living off of the cash flow that comes from rental properties, then sure, you would maybe want to pay off those mortgages so that you, because you have a cash flow centered approach. But again, yeah, that's the beauty of having that money to play with, having that lump sum to play with. Yes. So, but that being said, I mean, there's also the psychological component as well of, you know, we're talking about $200 a month. It's not a huge amount of money. So if putting that $200 a month encourages you to save $200 more than you otherwise would have, then you may as well go for it.

I'm meaning you may as well put that $200 a month back into the principle if that results in additional savings above and beyond the, the half of your income that you are already saving. Well, and to your point, Paula, if she has $80,000 sitting in emergency cash, she already knows that's way too much money in emergency cash. I'm guessing from that that she's got positive cash flow. If you've got positive cash flow, why isn't she taking that whole thing? And at the very least, putting it all back in toward the mortgage. Right.

Yeah. So I think the $80,000 in the checking account, I assume, comes from the practice of saving half of their combined income. Right. She mentioned $2,000 per month goes towards various insurance policies, and it doesn't sound like a whole lot else is going into investments. So I guess I'm making the assumption that a lot of what she's saving is just getting piled literally into a savings account. Yeah, I would too. Yeah.

So let's talk about what to do with that. I mean, we've kind of covered the topic of what resources to go to to to learn more about investing. Oh, I do actually have a couple books to throw on your library book pile. Okay, cool. Share them. And we'll put links to all of these in the show notes. Again, the show notes are at Afford Anything.com slash episode 108. A book that I like written by a Canadian author, these are a couple older books, by the way, Paula.

One is called The Wealthy Barber. And I really like it because it's a story. And he says, David Chilton, the author of the book, says that if your financial plan, to your point earlier, doesn't fit on like a bar napkin. It's too complex. Like, if you can't explain to your friends what your overall strategy is because you're, financial advisors made it so complex, well, then it's too complex. It needs to be very simple. So I think that was the first book I thought of when you were talking about the theme among the three authors you were talking about. My favorite book from a financial planning broad strokes point of view is written

by a guy named Rick Edelman and it's called The Truth About Money. And it's funny. It's incredibly even-handed. Clearly doesn't have, you know, she's very worried about her financial advisor's agenda. I like how you get a very even-handed approach. A lot of time I'll go read a blog. or I'll go read a book, and I will definitely see the person's point of view. This book is so, so even-handed. I absolutely love it. And because it's written with a lot of humor, it's easy to get through it, too. Yeah, absolutely.

You know, to Whitney, to your concern about advisors having different points of views and different agendas, a couple of things that I would say to that. Number one, that's part of the reason that I enjoy reading books so much is because the goal of the, with some exceptions, sometimes there are authors who are trying to sell you upsell you within the pages of the book. But for the most part, most books that I've read, the only agenda that the author has is to sell that book, in which case, okay, it's a $10 book. Sure, I'll buy it, you know, or get it from the library, whatever. Yeah, but it doesn't matter, right? So generally speaking, I find that what I read in books tends to be unbiased because the motivation

of the author is simply to sell a $10 or a $15 book. You read so much better books than I do, because some of the authors that approach me for stacking Benjamins clearly are trying to push an agenda that goes along with a bigger platform. But the writer is writing a book from a point of view because of the fact that it fits with whatever they're large. They're not trying to make money from that $10 book. They're trying to use it as a thought leader to become a thought leader in space. Right, right. That's true. I do get a lot of press releases from people who are pushing books like that. But I've noticed that those books don't tend to succeed. Like they don't stay in the cultural dialogue for very long.

So books that have been around for a long time, books that have become bestsellers or are known as financial classics, those tend to be, you know, crowdsourced, democratized and filtered out as the ones that actually have valuable nuggets within them. Amen. Broadly speaking. The other thing that I would say, Whitney, is if you do talk to an advisor, make sure that the advisor has what's known as a fiduciary duty. And what that means is that they are required by law to give you advice that is in your best interest. So ask the direct question, do you have a fiduciary duty or do you have a fiduciary obligation? And if the answer is anything other than an unequivocal, yes, walk away. Because if a person does not have a fiduciary duty, then they're merely held to a standard that is called suitability, meaning that they can give you suitability.

meaning that they can give you suitable advice, but not necessarily the advice that's in your best interest, which is a much weaker bar, a much lower bar to hit. So only talk to advisors that have fiduciary duties. And ideally advisors who, you know, charge by the hour and charge you money. I've talked to so many people who are like, oh, but there's this person. He said he'd help out. And it's going to be totally free. And I'm like, oh, no, no, no, you don't want that. You do not.

Exactly. free. They're working from the goodness of their heart, Paula. Exactly. Exactly. I had this conversation the other day with my friend Amanda, where she's got a bunch of student loan debt and somebody approached and was like, oh, yeah, I've got this thing. I'll help you pay it off. I'll meet with you and tell you exactly what to do. It'll be totally free. And he totally pitched her on the, like, I'm doing this for you as a friend. Wow. And so, and he gave her all of this terrible, terrible advice. And so she asked. me about it, you know, she was like, but he said he's doing it as a friend. And I was like, Amanda, would he help you move? Would he show up to your house on a Saturday morning at 7 a.m. and help you like lift your furniture. You're like, Amanda, you were born at night, but not last night. Come on. Yeah, exactly. Because if he would actually show up and help you move and load boxes

into a U-Haul, sure, then he's a friend. If not, he's just, you know, he's just somebody who's trying to make money off of you by giving you terrible advice. There's something else I do on top of that, which a lot of people don't know. There's this regulatory agency called FINRA and F-I-N-R-A, and if you go to their, they've got a cool button on their site, which is broker-check. And you can click on that and put in the name of your advisor, and you'll also see if there been any complaints against them.

And that doesn't mean, by the way, if there has been a complaint, it doesn't mean that the advisor's bad because the advisor can't do anything about people filing a complaint. It shows every single one. But Paula, if I've got somebody I'm talking to that has, you know, four complaints and they're all the same, like on my record, I had a complaint. And if you went and looked at my record, I don't even know if it's there anymore or not. I haven't checked. But if you go and look at my old record from way back when when I was an advisor, I had a complaint,

could do anything about it. But it brings up this great conversation with them about, you know, what's this thing all about? But you can also see a string of complaints. It seems like whenever we do headlines on our show about people getting ripped off, you could have gone to broker check and you'd see this long line of disciplinary action against that person before people got really, really taken. Yeah. Yeah, absolutely. So, Joe, a couple more things that I want to address with regard to Whitney's question.

So she mentioned that she is not contributing to a 401K. Whitney, I would say, unless there's some very special goal or circumstance that would push you towards needing that money early, I would put that money into 401K because, and I understand you're getting the employer match whether or not you contribute, which is awesome. That's a great benefit. But remember, the money that you put into a 401k will go in tax deferred and it will grow tax deferred. So you get kind of two tax benefits or two tax advantages within that space. Also, and I guess this is a a bit of a smaller point, but if you were to be sued for any reason, the money in your 401k has a higher degree of protection than money that's just sitting around in your checking account. Yeah, fantastic. No reason not to do it. Yeah, absolutely. I mean, the only reason that I could think of is, again, if you wanted to tap that money at the age of 31 years old, if you want to tap that money at the age of 40 or 45, then I'm, there, that's like a whole different window of conversation into, you know, early retirement withdrawal strategies. Yeah, but hear me out on this, Paula, which is that she's going to need money after 59 and a half, no matter what. So let's build that pot a little bit too. Yeah, absolutely.

Absolutely. I agree with you there. As for the $80,000 that's sitting in your checking account, Joe, what would you suggest that she do with that since that money is already kind of sitting there? There's some portion of it, Whitney, that will stay in savings as an emergency fund, and that should be at least three months worth of your expenses. As for the rest of it. If she takes my advice and starts with the end of mine and sets up goals, then she's going to see where the holes are in those goals or which ones have the biggest opportunity for her or excites her the most if she's ahead of the game on all of her goals so she can speed those up or maybe take less risk, whichever she decides to do toward those. I think that's the first step. Once you know what you're heading toward, then the investments take care of themselves.

So that's actually what I do. I would figure out the plan of what she wants and do that little math equation. and find out if she's ahead or behind and then use it to fill in holes. Okay. So let's say that her goal is to retire at the age of 45. What would you do? Okay. So then I would, number one, take a look at, you talked about her text deferred accounts.

I'd look at those. But then I also, we've got that age 45 thing looming out there. So to that end, depending on how far she is from 45, do we create an income-producing vehicle, which is going to throw off income that she can live on later, like a tree that's just always bearing fruit? Or are we going to use more of a capital gain strategy? Because really, you know, a gain is a gain is a gain. People get caught up and, hey, I want something that pays dividends. Really? Because if I had a stock that went up a billion percent, would you care that I made the money that way? If it was faster, it really doesn't matter. But you need to know

what your strategy is. So I would set up some type of decide what strategy I'm going with there. Am I going to create a tree that bears fruit that I live off of? Or am I going to systematically sell stuff after age 45. And in that case, once again, the investments, depending on the time frame, pick themselves. So in other words, first decide, are you optimizing for cash flow or are you optimizing for capital appreciation and growth? You always say things so much more succinctly than I do. I think about this a lot, I guess. I don't know. I can say your phrase in 600 words. All right. Final thing before we move on to the next question, that whole life insurance policy.

Yeah. Joe, I'll let you take this one because I think you and I are thinking exactly the same thing. Well, here's the thing. Whole life insurance isn't bad. And a lot of people will tell you it's horrible and get rid of it. By the way, I'm probably going to tell you to get rid of it. But it's not that it's bad or it's horrible. It's that it doesn't fit a lot of people.

So whole life insurance is meant to last your whole life. The problem with that, most people build enough assets by the time they reach, you know, financial independence. maybe that's in your 40s, 50, 60s, whenever, that once you reach financial independence, do you really need that life insurance? The answer probably is no, because you have enough money that you could self-insure. So whole life for that reason also is incredibly the growth of the policy itself. There's this thing called cash value. It's put into very conservative instruments to ensure that it will last your whole life

because the insurance company does know what's going to happen in the future. You don't know what's going to happen in the future. So they do things very conservatively. your money is invested for a long time in something that is very, very slow growth oriented. And because it's providing insurance for your 70s, 80s, 90s, 100, those are the expensive time in your life because the insurance company thinks you're going to die. So for that reason, whole life insurance, way more expensive than term life insurance, you know, looking at any of the insurance providers out there, and there's some that I really like,

but looking at any of the insurance providers out there that are reputable, you will find probably a shockingly different price for insurance. Now, remember this, with term insurance, when that terms over, it's going to be one or two things. It's going to be either grossly more expensive to buy a new policy or it's just going to go buy-bye. So make sure that you're setting your plan. But Whitney seems like she's doing so many things, right, Paula? It seems to me that unless she has some very special circumstances, a term life policy

be a better way to go for her than a whole life. Yeah, absolutely. I think there are very few circumstances in which whole life policies make sense. If you're extremely wealthy and you are using Whole Life as a tax planning strategy, that's one instance. If you, Joe, you and I talked about this before, if you plan on being cryonically frozen upon death. Like me. And you use a Whole Life policy in order to pay for the cost of that, because that's about $200,000. That's the other major use case that I can see for it. Beyond that, particularly for a newer policy, I don't see any reason to stay in a whole life plan.

No. No. I mean, just a couple more. If she has special needs children, okay, maybe there's some opportunities there to strategize if she owns a business, you know, is like a key man policy. But yeah, nope. Correct. Awesome. Well, thank you so much, Whitney, for calling in with that question.

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They're creditcesami.com. Creditcesami.com. Our next question comes from Kim. Hi, Paula. It's Kim. My question's about the 4% rule when it comes to building an early retirement nest egg. when calculating your goal savings amount for retirement based on the 4% rule, do you have to also account for any tax implications upon which are all of these funds?

For example, if I needed 50K a year to live off of in order to retire, when I need to calculate the 4% rule at more than 50K to account for any taxes I may have to pay. Is there a way to avoid any of this? Thanks for your help. Love your show. Kim, that's an excellent question. Before I answer, I want to define the 4% rule for the sake of anyone else who's listening. who isn't familiar with it. So the 4% rule of thumb is a broad rule of thumb that states that in

retirement, a person could safely withdraw 4% of their portfolio in year one and 4% adjusted for inflation every subsequent year and still have a reasonable chance of not outliving their money. So in other words, if you were to retire and you had a portfolio of a million dollars, you could, according to the 4% rule of thumb, safely withdraw $40,000, which is 4% of $1 million, in your first year of retirement, and then 40,000 adjusted for inflation every subsequent year, and you would still have a reasonable likelihood of not outliving your money. Which your definition answers her question, because it's the amount off the top of the portfolio. So the answer to Kim's question then is it depends on the tax treatment of the investment.

Yeah, because taxes are included. If it's pre-tax money, you're talking about 4% off the top, and guess what? Part of that has to go to the tax man. Part of it has to go to you. The 4% rule does not talk about which pocket, whose pocket it goes in if it's yours or the governments. Right. Exactly. So if that million dollar portfolio exists in a Roth 401k or a Roth IRA, well, then you're not going to be paying taxes on that. So awesome. That all goes to you. If, on the other hand, that withdrawal comes from a traditional account, like a Trad 401K or a Tradrera, then yeah, then you've got to pay taxes on it. So when you're making your projections, you'll have to figure out whether you, and you'll know this because you know what type of accounts you're contributing to.

Are you currently contributing to mostly Roth accounts or mostly trad accounts? Trad accounts. Listen to you. Using all the cool words. The slang. That's right. The tax treatment slang. Is that the slang all the money nerds are using these days?

I'm so out of it, right. I have a bigger issue, which is, well, and let's talk. first about can some of this be avoided? The answer to that question, I think, is Paula, I mean, as far as I know, that you can't avoid it, but you should have a good tax strategy for withdrawal. You know how people have tax strategies to figure out what the best tax treatment is of money going into investments? Well, you want to have the same thing on the way out. And this is a big part of planning that I think people forget is that other end of the stick. When money comes out, I would take a look at where the tax bracket lines are. So let's, as an example, let's say you have money

in a trad 401k. How's that? And in a Roth 401k, well, I might go up to the tax bracket line, taking money out of my traditional account, and then use the Roth for money above that tax bracket line. Of course, that depends on how much money I have in each account. But in that way, I might be in, you know, living midway up a higher tax bracket and keep my traditional money that's going to be taxed when I take it out. I might be able to have less of that tax because I'm taking it out for the lower tax treatments all the way through my financially independent years. So I don't think there's a way around it, but there certainly is tax strategies that you can use. All right. Let's say that you want to withdraw $50,000 in total. Can you give an example that illustrates

what you just said? Yeah. So because money in a 401k is going to be or a traditional IRA that's been deducted, that money is all going to be taxed when you pull it out. We want to look at tax, tax bracket. So looking at 2018, let's be all cool and look at the new year stuff, up to 9,525 is going to get taxed at 10%. But I love taking that out of a traditional because I'm

paying the lowest tax rate on that. Then up to 38,700, by the way, this is for single people. 38,700, that's in the 15% bracket. So if I'm trying to live on 50,000, I'll take the first 38,700 out of my traditional 401K

and traditional IRA. And then the next 11,300, the money over 38,700, I'll take out of the Roth. That money, Paula, if I would have taken it out of the traditional, I would have paid 25% of that to the man. And instead, because I'm using the Roth and the traditional together, I'm being taxed maximum at the 15% bracket and all the money that would have been taxed at 25% is now not being taxed. So I'm living midway into the 25% bracket and paying taxed. as if I'm at the top of the 15. Now, it isn't so sexy if you're married. Looking at married filing jointly, 19,000 to 77,000 is 15% bracket. But then again, you know, if you're married and you're

living on, instead of one person living on 50, 2 people trying to live on 80, 90,000, you can still do the same thing. The other thing to know about tax management in retirement is, remember, you are taxed on the income that you take out of your portfolio. You're taxed on the income that you realize a given year, you are not taxed on the assets that you hold, well, other than property tax. So, for example, if upon going into retirement you have a house that is completely paid for, that lowers your cost of living, thereby lowering the amount of income that you need, which of course naturally keeps your taxes low. So in other words, the more that you can design your life in such a way that you don't need a lot of income in retirement, and you would do so by things like

having a house that's totally paid off, having vehicles that are totally paid off, you know, being debt-free, if it fits your lifestyle, living in a place with a generally low cost of living, by doing those things, you can not pull that much money out of your portfolio and therefore not pay that much in taxes on it. That's a great point. When I was a financial planner, one of the first things we'd always look at is just recurring expenses. You know, what recurring expenses do people have that we can lower or eliminate?

If we can reduce that, then we can reliably, to your point, not have to take out as much. My Spotify premium account. I love it. Nine bucks a month. I'm not going without that, baby. All right. Paul, I've got one more thing to add here, which is the 4% rule that she quotes is pretty interesting because it's not the ironclad rule that a lot of people think that it is.

And I hear the 4% rule quoted a lot. I've seen book authors talk about using the 4% rule when planning your retirement. And I think people have to dig a little deeper because a lot of people in certified financial planner academia land. are kind of questioning the 4% rule and have poked some holes in it that are probably important for people to know. I've read about this as well. So the biggest criticism of the 4% rule with regard to early retirement planning specifically is that the 4% rule originated from a study known as the Trinity study in which researchers analyzed the likelihood of an individual being able to live on their retirement portfolio over the span of a 30-year retirement. So the Trinity study looked at, you know, if you retire at the age of 65, you live to the age of 95 and you withdraw 4% of your portfolio annually, adjusted for inflation after year one. Under that set of circumstances, they found that in about 92-ish percent of cases, the individual, the retiree, has a reasonable likelihood of not outliving their portfolio.

However, that initial research was only concocted over a 30-year retirement. So the research that established the 4% rule was not designed to service a 40-year or 50-year or 60-year retirement. So it wasn't designed for early retirees. And of course, when you have a longer time horizon, necessarily that means that you have more uncertainty. More time means more uncertainty, more shocks, more potential for things to go wrong. And because of that, a lot of people criticize the idea of the 4% rule, if a person, is going to retire in their 40s or 50s. Yeah, good for people to know.

Right. However, Joe, the position that I take on that is that I think it is perfectly fine to plan for an early retirement based on the 4% rule if you can maintain flexibility during times of market dips. A lot of the research that the simulations, the computer simulations that are done around the 4% rule assume that a person will withdraw precisely 4.00% percent. plus adjusted for inflation, regardless of what is happening in the overall market. But the reality of it is a person's needs change and a person's desires change based on the external circumstances around them. So for example, during the Great Recession in 2008, 2009, the national mood was one of frugality. The national mood was one of spending a little bit less. And so if you are retired and you are willing to cut back on discretionary spending during recessionary periods, then I think the 4% rule could still completely work, as long as you maintain that flexibility. I think it mostly works. The place that the 4% rule doesn't work is if you set off on a journey using the 4% rule and somewhere beyond the time where you can easily reestablish whatever income stream you had, let's say you're working at a high paying job.

And I think of our friend Jeremy at Go Curry Cracker. He was an engineer, right, making good money with an engineering firm, left that firm. Let's say he gets far enough out of the job market that he can't very quickly. He's cut ties with that he can't very quickly make that happen again. And he has some disability happen where he has to withdraw more than that, like a personal circumstance. Most of the 4% rule issues are based on what you're talking about, Paula. But there's also that personal issue that we really can't predict. How would you recommend then that a person pursuing early retirement deal with that uncertainty? I think somebody who's going to have that fire strategy.

financial independence retire early strategy those people I think need to have a larger cash reserve and I think I would look at closer to a 5% rule like I'm only going to take 4% out but I can handle my portfolio can withstand taking 5% out and I'm still okay I would just look at a higher percentage I'd build in some shocks you know to both of those you're never going to be 100% certain Paula but to your point if you can withstand the market dips and to mine you build in some shock absorbers. So in case you have to take out more than that 4%, you're still going to be okay, then you're good. Wait, do you mean a 5% rule as in the person ought to take out 5% or do you mean more like the person could? You're going to take out 4, but you could take

out 5 and you're still going to be okay. Yeah. And Joe, I think I've got an approach that is similar-ish, or at least it's along the same vein, probably two different languages expressing the same thing. Mine is a little bit more based on spending habits during. retirement. Again, being more frugal at times when there are recessions, being more frugal at times of market dips, and also maintaining some light part-time income in an early retirement. I mean, if you retire at the age of 45, you could still work five hours a week. It really doesn't have to be that much and just have a little bit of extra coming in that, again, could provide that additional padding without requiring you to punch the clock 40 to 50 hours a week. Yeah, agreed.

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That's freshbooks.com slash P-A-U-L-A. And enter Afford Anything in the How Did You Hear About Us section. Our next question comes from Susan. Hello, Paula. Thank you so much for your excellent podcast. I particularly loved your episode on early retirement, and I had a question for you, which is, with the Roth IRA conversion ladder, if I convert resources from a 503B retirement savings plan to a traditional IRA as the first step in the ladder, how long do I have to keep it in a traditional IRA

before I can then roll it over into a Roth IRA? I understand that I have to keep the money in the Roth IRA for five years, but I'm not clear on how long that I have to keep it in that intermediary step of a traditional IRA. Could I roll it into traditional IRA and then just a week later or some short period of time roll it into a Roth? Thank you so much for letting me know. Susan, thanks for that question. You know, Paula, I think I've got this one. Cool. Well, Paula and I play tax advisors on the radio. No, I'm kidding. We don't even do that. We are not tax advisors. So I'm I'm going to say that first. This is a fairly quick answer, which is that the amount of time that you need between these moves hasn't been defined by the IRS, to my knowledge, but they have to be

separate. The IRS says they have to be separate moves. So what does that mean? You can't just do it all at once and call it good. So most advisors that I know would tell you that you should maybe wait a day or two, you know, some people put a week, two weeks. Really, so far, to my knowledge, I haven't seeing the IRS dispute those too much, you just need to make sure that they're separate, separate moves. And I think, Paula, I think that does it. Yeah, absolutely. You know, the thing that I'll add to that is that I've had experience in doing these wacky conversions, trying to make a backdoor Roth contribution where I have to put money first into a non-deductible TRAD IRA and then convert that money into a Roth account. When I've done that, I put the money into the non-deductible

a trat IRA. And then I just wait for like a day or two. And then I convert it into a Roth. So, yeah, you don't have to wait that long. 24 to 48 hours should be fine in most cases. Check with your tax advisor. If you're really worried. But I, but yeah. Yeah. And that's the other thing is anytime that you're doing something like making Roth conversions, whether it's a backdoor Roth conversion or you're using a Roth conversion ladder, these are all complicated tax strategies. so you will always want to have a CPA in your corner guiding you every step of the way. It's particularly for, you know, if, and I'm not saying you, Susan, but just generally, for people who come from a background of frugality, it can sometimes be psychologically a little bit difficult to get over that hurdle of paying high professional fees. But there are some things that are absolutely worth paying for and paying a CPA, a really good CPA is, in my opinion, absolutely worth it.

One of the things that they mention in the book, The Millionaire Next Door, is most American, or at least the majority of itself made millionaires whom the authors of that book studied were famously frugal in many, many areas of their life, like what car they drove, what clothes they wore. But getting good professional advice, such as from a CPA was something that they did not skimp on. Because it's a category where every eye needs to be dotted correctly, every T needs to be crossed correctly. So you just want to make sure that you've got somebody looking after that. Amen. Sweet. All right. Well, that is our show for today.

Joe, thank you so much for joining me on this episode. Are we done already? Already. We are. I think we've done it. That was so fun, as always. Joe, if people want to hear more about you, where can they find you? I live in my mom's basement, which is located at stackybenchement.com, where our show, which is

variety show. It is a very fast-paced. We generally have a couple headlines. We have a guest on for maybe 15 minutes. And then we answer a couple questions. That's at stacking benjamins.com. Awesome. And somebody we know is on our show every week. Oh, and who is that? Her name, you wouldn't know her, but her name is Paula Pant. She sounds cool. That's a cool name. She's incredibly cool. Awesome. Well, Joe, thank you so much for joining. us and thank you to everyone who called in with a question, everybody who's listening. Thank you all so much. Coming up on future episodes of this podcast, on Christmas Day, we are airing an interview with Will Bowen about how to create a complaint-free world. Will started a movement to reduce complaining, and we'll talk about why that matters and how that can be achieved.

We also have an interview with Tanya and Mark. They retired at the age of 30. and 41, respectively, and they blog at Our Next Life. So we'll be chatting with them about how they retired in their late 30s, early 40s. We also have an interview with Natalie Sisson, the suitcase entrepreneur. So all of that is coming up on future episodes of this podcast. My name is Paula Pan. I'm the host of the Afford Anything podcast. Thank you so much for joining us. If you enjoyed today's show, please head to iTunes, Stitcher Overcast, wherever it is that you listen to podcasts and leave a review and hit subscribe. Thanks. And don't forget, you can You can get the show notes at afford anything.com slash episode 108.

Catch you next week.