Frugal Professor

To get to Step 3, we’ve first learned to be frugal in Step 1, which will generate savings for us. In Step 2, we’ve learned to maximize our savings by minimizing our tax burden using tax-deferred accounts like 401k’s, etc. In Step 3, we’ll learn what to do with the piles of money in our 401k’s, etc.

For reasons discussed in Step 2, you should accumulate a lot of money in tax-deferred accounts like 401k’s, 457’s, 403b’s, 401a’s, and IRA’s. These fancy numbers are nothing more than labels on the outside of a bucket where you are storing your money. Inside each bucket is a pile of cash.

Piles of cash are generally not good investments since inflation erode their value from the pile at a rate of 2-3% per year. As a result, you will want to invest in something that beats inflation.

Investors will usually chose to invest this cash in stocks, which is the literal ownership of a company. If I buy 1 share of Apple stock, currently priced at $99.89, I’m buying a portion of this company and am entitled to future profits of the company which are paid out in the form of dividends and share repurchases. Apple has 5.48B shares outstanding, so buying 1 share will entitle you to 1/5,480,000,000 of the company’s profits.

Alternatively, you can buy corporate or government bonds, which is simply loaning a company or government money for a specified interest rate.

The most important equation for investors is the following:

Real Return = Market Return – Inflation – Investment Management Fees – Taxes

Let’s break this down one term at a time.

• Real Return: This corresponds to the growth in purchasing power of your money over time. If you achieve a real return of 5% over 1 year, you will be able to buy the equivalent of 5% more stuff 1 year from now than you can today. If you could buy 1 candy bar before, in a year you can buy 1.05 candy bars after a real return of 5%, after taking inflation, etc. into consideration.
• Market Return: If you were to invest in every company in the U.S., you’d get the “market return.” Apple is the biggest company in the world, so it would make sense to hold more weight of Apple in your portfolio than Joe’s Taco Stand, but if you want true exposure to the entire U.S. economy, you’d want to down a sliver of ownership in Joe’s Taco Stand as well. This “market return” is the aggregate performance of the stock market and it’s essentially impossible to beat it through stock picking or market timing. The sooner you learn this lesson, the richer you will be.
• Inflation: $1 in cash today is worth less than $1 cash in the future due to inflation. Prices rise over time, eroding the purchasing power of cash. Historically this runs in the neighborhood of 2-3%.
• Investment Management Fees: If you hire a financial planner, they’ll charge you a 1% assets-under management fee regardless of their performance. If you adhere to the advice on this blog, will want to avoid them like the plague. Further, if you invest in actively managed mutual funds, you’ll face fund management fees of 1% per year or so. Why does this matter? Let’s look at our equation and assume a market return of 6%, inflation of 3% and ignore taxes for now. This gives us a Real Return = 6% – 3% – Investment Management Fees. If Investment Management Fees are 0, the Real Return would be 3%. If instead, I used a financial planner and actively managed mutual funds, my Real Return = 6% – 3% – (1% financial planner fee + 1% active mutual fund fee) = 1%. Again, Investment Management Fees are one of the two things you can control (the other being taxes), and you can make huge mistakes here. By having my fees be 2%/year, my Real Returns plummeted from 3% to 1%, a reduction of 66% in the potential growth of my investments.
• Taxes: When you buy a stock for $100 and sell it for $150, you incur a capital gains tax. The $100 purchase price is known as the “cost basis” – simply what you bought it for. When you sell it for $150, you incur a $50 capital gain, since the sales price of $150 is $50 higher than the $100 purchase price. Capital gains rates are published here. As of the time of this writing, they range from 0%-20%, depending on your income level, but for most people will be 15%. Given that taxes cause a performance drag on the investment, it’s best to avoid them. To avoid them, the investor in the above example could simply have deferred the selling of the stock, and thus pushed the capital gains tax down the road. If your money is in a tax advantaged 401k, 401a, 457, 403b, or IRA, you can ignore capital gains and dividends taxes. However, if your money is in a taxable brokerage account, you’ll need to pay special attention to taxes.

What are index funds and why they will be your best friend:

You can’t beat the market. Hundreds of research studies have concluded this. As a result, the best thing you can do to maximize your real returns is to manage the two levers in the above equation that you can control: Investment Management Fees and Taxes. To minimize Investment Management Fees, simply avoid financial planners. Also, avoid actively managed mutual funds. Actively managed mutual funds pay an investment adviser a healthy salary to try to beat the market. This is a fool’s errand, and time and time again, research shows that actively managed fund managers underperform the market. Jack Bogle founded Vanguard decades ago with this simple fact in mind. He set out to design a product that captured the market return at a rock-bottom investment management fee. This product is known as an Index Fund, and it simply tracks the market at rock-bottom fees.

With one index fund, such as the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), you own the entire U.S. economy for a cost of 0.04% per year (as shown by the “expense ratio” listed here). If you have $100k invested in this fund at Vanguard, it will only cost you $40/year in management fees. This is an unbelievable technological breakthrough that has enabled normal Joe Shmoe’s like you can me to capture the returns of the U.S. economy for essentially $0 management fees. What does this fund invest in? Thousands of companies, in proportion to their size. Here are the largest holdings in the Vanguard Total Stock Market Index Fund per the link above:

Month-end ten largest holdings
(15.4% of total net assets) as of 06/30/2016
1 Apple Inc.
2 Alphabet Inc.
3 Exxon Mobil Corp.
4 Microsoft Corp.
5 Johnson & Johnson
6 General Electric Co.
7 Amazon.com Inc.
8 Berkshire Hathaway Inc.
9 AT&T Inc.
10 Facebook Inc.

As far as what mutual funds to invest in, I’d recommend one of two routes:

Option 1.) Invest 100% of every penny you have saved in a target retirement fund offered by Vanguard (or Fidelity or Schwab). With these funds, you simply select your retirement year, say 2050, and invest every penny into these funds. Gradually these funds become less risky over time and invest more in more in bonds, which historically have had lower volatilies.  These target retirement funds have fees around 0.16%/year (link) and achieve such low expenses by simply investing directly into index funds for you (link). These target retirement funds only invest in 4 funds. For example, the 2050 retirement fund has the following allocation:

1 Vanguard Total Stock Market Index Fund Investor Shares 54.3%
2 Vanguard Total International Stock Index Fund Investor Shares 35.8%
3 Vanguard Total Bond Market II Index Fund Investor Shares* 6.9%
4 Vanguard Total International Bond Index Fund Investor Shares 3.0%

Option 2.) Option 2 is investing directly into the underlying funds yourself and capturing a slightly lower expense ratio by exploiting the lower expense ratio of Vanguard’s Admiral Shares. The Vanguard Total Stock Market Index Fund Investor Shares has an expense ratio of 0.16%, whereas the Admiral Shares version of the same fund costs 0.05%/year in fees. You only need $10k to purchase the admiral shares on your own outside of the target retirement fund, so it’s a relatively low hurdle to clear.

Option #2 is what I do personally. The downside of Option #2 is that the investor has to decide what percent to allocate to the U.S. fund vs the International fund vs the Bond fund, etc. If anyone claims to know the optimal portfolio allocation, they’re blowing hot air at you. Nobody knows what is optimal. Not even Vanguard’s Target Retirement Funds know what’s optimal. They’re taking a guess, but it’s just a guess.

Going forward I’ll share my portfolio holdings. As of today, I’m 70% U.S. Equity, 30% International Equity, but I don’t claim this is any better or worse than the Target Retirement allocation. It’s just a guess. And it’s not even a very good guess. I’ve sold a bunch of stocks recently to purchase a home so I haven’t even given much thought into how I should reallocate. But the current mix seems to be reasonable enough for me that I’m fine.

Disclaimers:

• You will lose your shirt in the stock market. In 2008 I lost a good $50k or so, which was a lot of money to me at the time. It hurt. A lot. Losing money in real life is a lot harder than it is to hypothetically lose money. But I rode it out and it’s all fine.
• Markets are extremely volatile over the short-term. However, you’re not investing for the short-term. You’re investing for the long term over the next several decades. As a result, day-to-day, week-to-week, and month-to-month swings in stock prices should be  irrelevant to you. Ignore the financial press like CNBC and stock market pundits who spout nonsense. Ignoring financial news will make you a much happier and wealthier investor.
• Don’t try to time the market. Like trying to beat the market through picking of stocks, trying to time the peaks and troughs of the market is also a fool’s errand. Avoid this by simply investing your accumulated savings gradually over time and avoid selling unless you really have to (like I just did to buy a home).

 

So that rounds up the series on how to accumulate wealth and be a millionaire. Stay tuned for our financial updates in the future as we follow these dumb-simple steps to achieve financial independence.

 

Links to other steps in series:

• Step 1: Be frugal
• Step 2: Minimize your tax burden
• Monthly updates where we follow our own advice

***** The below blog post is a bit stale now, as it was written before the massive tax law change of 2018. If you want my latest and greatest thoughts on the tax code, you can find them in this pdf here. *****

 

 

*** The following post was written based on 2015 tax numbers (standard deduction, personal exemption, etc). The mechanics are still sound, though the actual numbers will now be slightly off. ***

 

Taxes in the U.S. are complicated. They seem like a huge black box, but here’s a brief summary that should capture most of what you need to know.

Step 1: Calculate taxable income

What you first need to understand is that all U.S. tax calculations are based on something called taxable income. Taxable income is pretty easily computed, and the equation is shown below. It’s equal to your wages minus your pre-tax contributions (such as healthcare premiums, retirement contributions, etc.) minus your standard or itemized deductions (more on this below) minus personal exemptions (simply $4,000 times the number of people at home).

 

Gross Income

— Pre-tax payroll deductions (401k, healthcare premiums, etc.)

— Standard or Itemized Deduction (See below)

— Personal Exemptions ($4,000 * number of people in home)

= Taxable Income

 

Standard or Itemized Deduction

In the U.S., you get to deduct a certain dollar amount from your taxable income. This occurs in one of two ways: 1.) Standard Deduction or 2.) Itemized Deduction.

1.) Standard Deduction (70% of American’s fall under this category)

If you’re married filing jointly, the standard deduction is $12,600 for married households filing jointly (half that if single) in 2016.

2.) Itemized Deduction (30% of American’s fall under this category)

If you have itemized deductions in excess of $12,600, then it makes sense to itemize. Popular items to deduce are: mortgage interest, property taxes, state income tax, charitable contributions, and healthcare expenses. But be careful of the economic interpretation here. If I pay $13,000 in mortgage interest in a given year, I may think I’m getting a good deal because it’s deductible. But remember that you were getting a $12,600 deduction for free even if you didn’t have a mortgage. So by paying $13,000/year in mortgage interest only reduces your taxable income by $400 over the standard deduction.

 

Let’s plug in some numbers to make this more tractable. Say I make $100k in a year, contribute $10k to a 401k and $10k in pre-tax insurance premiums. Let’s say I also take the standard deduction and am married with 5 kids at home.

Taxable income = $100k – $10k – $10k – $12.6k – $28k = $39.4k.

Let’s cross-check using Turbotax’s Taxcaster Tool (link, though they also have apps for Android & Apple).

Unfortunately the tool doesn’t have a spot for pre-tax payroll deductions like 401k’s or healthcare premiums, so we have to subtract those out manually. Our income after 401k and healthcare premiums is $100k-$10k-$10k = $80k. This is the number we put into Turbotax as “Your Income.” After we input the $80k into Turbotax, it computes the taxable income as $39.4k, just as we had predicted above. Note the $12,600 standard deduction was claimed automatically as were the $28k in personal exemptions (7 people at home * $4k per person).

To illustrate the point of standard vs itemized deduction, note what happens to the “Total Deductions” line as I modify the mortgage interest. Let’s input $13k in mortgage interest to be consistent with the example mentioned previously.

Note that the standard deduction of $12,600 is no longer used, and instead has been replaced by the itemized deduction of $13,000. Again, in this scenario, $13,000 of mortgage interest only reduces our taxable income by $400 more than the standard deduction.

For the remainder of the post, I’ll revert to the standard deduction with taxable income of $39,400 as shown above.

 

Step 2: Calculate Taxes Owed

In the U.S., we have a progressive tax system. What this means is that the more money you make, the higher rate each dollar is taxed.

What this looks like in practice is like this (link):

So now that I have $39,400 in taxable income, we simply have to look at the above tables to find out how much we owe in taxes.

Since we’re married filing jointly, the table says that the first $18,450 in income is taxed at 10%, resulting in $1,845 in taxes. This leaves us with $20,950 ($39,400-$18,450) to be taxed at higher brackets. Since our taxable income does not exceed the 15% bracket (which caps out at $74,900), all of the remaining $20,950 will be taxed at 15%, resulting in an additional $3,142.50 in taxes owed. Summing the two gets us to $4,987.50 ($1,845+$3,142.50).

Does this number check with Taxcaster? Yes. Taxcaster computes taxes owed as $4,991. The few dollar difference is due to the fact that the IRS technically computes taxes with a look-up table rather than by actual math as we just used. This is a relic of the past that remains operable to this day.

So are we done yet? Unfortunately not. We still need to reduce our taxes with tax credits. Here’s what Turbotax says about tax credits:

Your allowable credits, including any and all child tax credits, American Opportunity Tax and Lifetime Learning credits, Child Care Credit, and the Earned Income Tax Credit. Credits reduce your tax bill dollar for dollar.

In my case, the Child Tax Credit is calculated as $1,000 * the number of kids at home, which is 5, resulting in a $5,000 Child Tax Credit. This credit begins to phase out at $110,000 in taxable income at a rate of 5% (if I had $111,000 in taxable income, then my Child Tax Credit would be reduced by $50 to $4,950). This credit is refundable, meaning that it if it is greater than the taxes owed I will receive a refund. My tax credit is $5,000, and with taxes owed of $4,987.50 I would actually receive a refund of $12.50 in this scenario on $100k in income. Note that this refund isn’t simply the returning of taxes I’ve paid into the government during the year. In Turtbotax I set the amount of taxes we’ve already paid to $0. This is a tax credit.

 

So in this example, I hope to have conveyed the following:

• You can actually compute your taxes. Once you understand the mechanics, you’ll see how you can benefit from the system.
• Don’t get fooled into thinking that itemizing is that much better than the standard deduction.
• The U.S. tax code is progressive. Lower levels of taxable income are taxed at low rates, and high levels of taxable income are taxed at higher rates. The first $18,450 per year in taxable income are always taxed at 10% for all people (even Warren Buffet). The next chunk is taxed at 15% and so on.
• Tax credits, particularly with kids, are complicated. The Earned Income Tax Credit and the Child Tax Credit are pretty difficult to understand. It’s beyond the scope of this blog to talk about all of the details.
• It pays to lower your taxable income. You can do so by having lots of kids (like I’ve done), but the much easier way of doing so is by maxing out employer sponsored retirement plans like 401k’s.

 

How I use the above knowledge to manage my tax liabilities

During your working years, the name of the game is tax deferral. In retirement, I plan to spend around $45k/year. Recall that $12,600 of this is tax free due to the standard deduction. Recall that another $8,000 is tax-free due to personal exemptions. The two combined bring my taxable income to $25k/year in retirement. $25k/year in taxable income is taxed at a very low rate (as shown by the tax tables above), so my main objective during my working years is to reduce my taxable income. Here’s how I’m doing so.

 

Gross income: $200k

— $9k 401a (max allowed by my employer)

— $18k 403b (max allowed by IRS)

— $18k 457 (max allowed by IRS)

— $6.75k HSA (max allowed by IRS)

— $1k healthcare premiums

— $12.6k Standard Deduction

— $28k Personal Exemptions ($4,000 * number of people in home)

= $104.65k Taxable income

 

My income is too high to benefit from a deductible traditional IRA, but if it were lower I’d further reduce my taxable income by $11k/year ($5.5k/person/year).

 

Now that we understand the tax code a little bit, here’s a tool that I put together which should be helpful for tax planning purposes: https://frugalprofessor.com/updated-tax-calculator/

 

Links to other steps in series:

• Step 1: Be frugal
• Step 3: Invest the savings wisely
• Monthly updates where we follow our own advice