Author: Mr. MFI

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Financial Updates

Bear Markets, Crypto Winter and Recession Worries: 2022 Q2 Portfolio Update

Time flies when life is happening. It’s beautiful here now that it’s summertime in upstate New York. Between work, vacation, trail running and generally trying to get outside as much as possible I’ve been writing a little less.

It feels like just yesterday I posted my first quarterly update ever for Q1 2022. Upon reflection I realized that I foolishly called it a “FI progress” post without actually stating how the numbers were stacking up against our rough FI number of $2M. Oops. Hope you’ll forgive me.

I decided that the FI journey is a slow one and updates against an FI number are probably better off in an annual wrap up. So, I changed the post name and I’ll worry about FI progress at the end of the year.

2022 Q2 Portfolio Update:

And we’re back with another quarterly update. This month my focus will be on showing you how much money we lost to help you feel better about your own losses. Well, losing money is never the goal but it happens some years none the less. We’re all in this together.

Q2 Total Investment Account (-$73,173) Value Changes:

Here’s an overview of my contributions, as broken down by the retirement tax triangle.

Q2 Account Contribution Summary (+$33,317):

  • Taxable (+$6,465)
  • Tax Free (+$1,825)
  • Tax Deferred (+$25,027)

In Q1 our overall investment accounts were down $73k after $33k in contributions. It’s understandable that some people feel that this feels like lighting dollar bills on fire. I put money in, and less money comes out! This investing stuff is dumb, I quit.

That’s how it goes though. The total stock market ETF VTI peaked at $243/share this year. Now it costs $191/share. At that peak I could have purchased 41 shares for $10,000 but now I’m buying 52 shares for the same $10,000. When it returns to the peak, our 52 shares will be worth $12,600.

The key is that you stay the course and don’t radically change your plan. I know that can be challenging emotionally. That’s why I gave people some ideas to avoid mistakes during a bear market.

Q2 Net Worth (-$54,803) Value Changes:

The crazy housing market continues to make me shake my head. I thought it was crazy that our home value went up 10% in Q1. Well, it did it again in Q2 up another 10% by $19,300 to $225,200.

We live in an area where this is highly unusual. With rising mortgage rates I can see this trend slowing way down and reversing.

Due to the bear stock market I completely stopped overpaying our 3.65% mortgage despite that being the prior plan. Stocks are getting cheaper so I think it’s a prudent tactical move. I ran the numbers on pre-paying my mortgage vs. invest in this article.

Taxable Accounts Value Change (-$27,472):

Here are our contributions to these accounts this quarter.

Q2 Taxable Account Contributions: +$6,465

  • Brokerage – Added $4,360 to the account.
  • iBonds – No added contributions. I still have $8,500 in “space” to buy more this year. However, it takes a lot of money to max our after tax 401k contributions for a future mega backdoor Roth contribution. I’ve been prioritizing buying stock funds in the brokerage account with extra money that I have.
  • Crypto – Bought $2,105 in BTC and ETH. I also sold my GUSD stablecoins and purchased BTC and ETH with that money.

We contributed $6,465 to our accounts and still saw our taxable accounts go down by $27k. The current bear market in both US stocks and crypto. The brokerage account is currently 100% stock so it’s highly volatile.

BTC is where we hold most of our crypto and that dropped 57% in Q2 alone. Yikes! This is why it’s important to be diversified and invest according to what level of risk you can handle.

I can sleep fine at night losing $7k. If that was a 57% drop in 3 months on a $1M portfolio pushing it down to $430,000 that would be terrifying.

The crypto portfolio has dropped so much that even with contributions it’s falling way below my target allocation of 1% of our total portfolio. I’ll keep adding to it slowly to try and get it back to $10-12k by the end of the year.

Tax Free Accounts Value Change (-$24,101):

Q2 Tax Free Account Contributions: +$1,825

  • Cash – No substantial changes. Normal ebb and flow.
  • Roth IRA – No changes. Already maxed for the year.
  • HSA – Added ~$1825 in contributions. Normal quarterly max out.

Our Roth accounts are invested in an 80/20 stock/bond portfolio so those took a good hit. The downside of maxing these out in Q1 is that there’s no ability to DCA into these accounts as they drop in value.

HSA’s dropped substantially on a percentage basis since they’re invested 100% in stock. That’s because they’re our retirement healthcare fund.

Tax Deferred Accounts Value Change (-$21,600):

The tax deferred account balances weren’t down as much in Q2 but unfortunately that was partly because we contributed a LOT more. We put in $25k and the account was still down $21.6k. That’s okay, those dollars will buy even more shares when they get put to work in the Roth at the end of the year.

Q2 Tax Deferred Account Contributions (+$25,027):

  • Mr. MFI 401k – $17,045* in my contributions. $2,857 in company contributions.
  • Mrs. MFI 401k – $5,125 in her contributions.

*Includes after tax contributions for a future mega backdoor Roth contribution.

Financial Topics On My Mind:

Each quarter I like to discuss some topics that are on my mind. They could be based on current financial events. They could be ideas based on thought provoking things that I’ve read. They could changes or ideas that I’m looking at implementing in our own portfolios.

Bear Markets

A bear market represents a 20% or more drop in the value of a market from the peak to the current value. We saw a bear market not long ago during the COVID crash of March 2020 when the S&P dropped 30%+. However, it was so short lived and recovered so quickly that it felt different than this. That along with the fact that at that time we were all more worried about dying than our portfolios.

Well, here we are again in early 2022 and we recently hit bear market territory for the S&P500 index. With a peak around 4800, anything below 3840 would be bear market territory. We hit that in June and at the time of this writing it’s recovered slightly above that but who knows how long that will last for.

What does that mean? Well, it does mean that stocks have started to drop from their sky high valuations to something more reasonable. If you’re far from retirement and still working this is a great opportunity to pick up shares for cheaper.

However, bear markets can be very difficult to deal with mentally. Especially if you haven’t been through one before. If you track your net worth you were flying high at the end of 2021. Our invested assets topped $1.2M and it felt amazing.

Then, a bear market hits and portfolios start dropping. If not for our very high savings rate continuously investing during the drop we’d be down over $200,000 and would have dropped out of the 7 figure club. I don’t care how experienced you are, that still sucks.

What to do? Well, stay the course, of course. If you have an investment plan now is the time to stick to that plan. Keep investing as you have been.

Avoid making drastic changes based on these short term events. Remember, you’re a long term investor and bear markets are typically 1-3 year events. More tips here for how to avoid investing mistakes when markets get crazy.

When markets get volatile your investments can get out of whack so be sure to review them every 6-12 months at a minimum to rebalance. Remember that rebalancing is effectively selling the high priced stuff and buying the low priced stuff.

Tactically, one thing that we changed is to stop overpaying on our mortgage. A while back I decided to pay an extra $500/mo towards our mortgage principle instead of investing that money. The goal being to pay off the mortgage a little faster.

With the market dropping and having a 3.65%, 30 year mortgage with only 7 years left on it with normal payments, we decided to stop the overpayments. Instead, that $500 is being invested in stock indexes in our brokerage account.

Crypto Winter

Brrr, crypto winter is upon us! Crypto values are tanking, stable coins are failing and some crypto companies are going out of business. In other words, shit is getting real in the crypto space after a couple years of euphoria.

I recently wrote about the risks of stablecoins. In there I spoke about counterparty risk as being a large one. One, we’re seeing that play out in multiple places. The stable coin UST lost its peg and its partner coin Luna went to zero.

If that wasn’t enough, Celsius and Voyager stopped allowing customer withdrawals. We found out that they were both loaning out large sums of money to others like 3 Arrows Capital (3AC) that were taking large risks with that money.

They’re halting customer withdrawals due to having “liquidity problems” which has many investors angry and worried. Its likely that they will lose some of their money and in the worst case they could lose it all. This is the problem with crypto companies that are unregulated. You don’t really know what risks they might be taking with your money.

All of that has put cryptocurrency prices into a free fall since they peaked in late 2021. Bitcoin, generally the most stable of all is down 68% from its peak!

There isn’t a market index to judge a crypto bear market but here is how much some popular coins have dropped from their peaks:

  • Bitcoin – 68%
  • Ethereum – 75%
  • Dogecoin – 80%
  • Luna – 100%

I have my crypto assets at Gemini which fortunately has been one of the safer platforms. That said, I’m still spooked by the possibility of their failure causing me to lose my money.

Focusing on what I can control in this situation, I’ve purchased a Trezor Model One hardware wallet. This allows me to transfer our crypto off of Gemini and hold it in cold storage. In plain English, it means that our crypto is in our possession and nothing happens to it if Gemini were to go bankrupt. They have no ownership of the asset.

Trezor Model One Hardware Wallet

With such a risk hanging out there, why did it take myself and so many others so long to consider becoming their own crypto custodian?

  1. Having a “hot wallet” on an exchange is just easier.
  2. There’s a lot more responsibility, complication and different risks in self custody.
  3. The risk of crypto companies freezing withdrawals and you possibly losing your assets is hard to gauge. Many assumed that it was a low probability risk.

Having now setup my own hardware wallet I can confirm that this NOT for the everyday person. There are so many ways that you can screw this up and lose your crypto. Long wallet addresses that must be correct, recovery seed words that must not be lost and nobody to help you if you mess it up.

Recession Worries

A bear market is one thing, but a recession is a separate concern. A recession is when the country gross domestic product (GDP) decreases for two consecutive quarters. GDP being the value of the goods and services produced by the country over a quarter.

US GDP went down by 1.5% in Q1 2022. If it goes down in Q2 then we will be considered in a recession. Because we only know about it after the fact, a recession is a lagging indicator.

Why Is This Happening?

Inflation is increasing and to combat that the Fed is increasing interest rates. Inflation is making costs go up and interest rates going up makes it more expensive for businesses to borrow money. Additionally, low unemployment means wages are increasing further squeezing businesses that compete for talent.

This usually results in companies tightening their belts with layoffs or bad businesses going bankrupt. Even popular companies like Tesla are beginning to lay off staff in areas where they grew too quickly.

Should You Be Worried?

Talking about recession may give you flashbacks to 2008 if you’re at least 35 years old. Should you be worried about a recession and the possibility of you losing your job?

Maybe, but this recession will be a little different. Right now we’re still at record low unemployment of 3.6%. While that will likely go up, there is no massive housing bubble or financial crisis to go along with it.

I think everyone need to determine their own personal level of risk based on their jobs, businesses and income streams. Anytime there is a slowdown the companies in worse financial shape including new ones are the most vulnerable. As are usually businesses that rely on more discretionary spending.

What Am I Doing?

I’ve been fortunate throughout my career to have a fairly safe job in the defense industry. I’m not a middle manager with a higher salary so I do feel a little more vulnerable. However, like other companies I know we’re struggling to hire people to fill our gaps AND retain the people that we have.

I do feel fairly safe but there are some actions that I’m taking to set myself for success if I were to get laid off.

  1. Increasing our liquid emergency fund – We have a decent ~8 month EF not including unemployment if I were to lose my job. However, cash is king when you lose your income. If there’s no job loss then we’ll invest it as a lump sum.
  2. Making your value known at work – The best employees that contribute most to the revenue and success of the company are the ones most likely to be laid off last. Be valuable and you’ll reduce the risk of getting the ax.
  3. Updating my resume – It never hurts to have that up to date so that you aren’t scrambling to do that after an emotional layoff.
  4. Working on a side hustle – ManagingFI financial coaching! Yes, I’m taking my knowledge and using it to help others achieve their financial goals. Interested in being a client? Contact me at contact@managingFI.com and tell me what you need help with.

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Investing

Target Date Funds: Good For Beginners, Bad For Retirement?

BLUF: Target date funds are an incredibly simple way to get started investing. However, as you approach retirement they may limit your options or not align with your goals if you use them incorrectly.

Sorry for the lack of posts lately ManagingFI family! I’ve been on vacation checking out Alaska using travel rewards, running some ultramarathons and generally enjoying the nice weather. NY weather is rough in the winter so we make the most of it when it’s nice!

J.L. Collins’ book The Simple Path To Wealth mentions using target date funds as a simple and easy way to get investing. But what are you really buying with a target date fund and how do they work?

Beyond understanding how they work, it’s important to understand the pros and cons of these funds. Like most things that are overly simple, there are pros and cons to using target date funds. We’re going to explore why they’re a pretty good option for new investors but you may want to plan on “graduating” from them along the way.

What Are Target Date Funds?

Target date funds are a type of mutual fund or ETF that are intended to be a simple, “all in one” investment option. Not everyone wants to put in the time to learn about asset allocation, stocks and bonds. Target date funds fill that need by offering a single fund to purchase that gives the owner a fully diversified portfolio.

Lets dive into the details of how these target date funds operate.

How Target Date Funds Work

The selling point for a target date fund is simplicity! The investor doesn’t need to know anything more about investing than the date that they want to retire. That’s where the name target date fund comes from. They are mutual funds that you select based on your target retirement date

Selecting A Target Date Fund

If you go to a target date fund provider like Vanguard you’ll see a number of funds with calendar years in 5 year increments that extend way out into the future. The image below shows only some of those funds from 2030-2050.

The full Vanguard lineup currently includes funds from 2015 (already retired) out to 2065.

To select a fund, you start with the approximate year that you expect to retire. For example, if a 40 year old in 2022 wants to retire at age 65 (25 years away) then they would be retiring in 2047.

There’s no “2047” fund in this case so you need to pick the date closest to 2047 which is 2045. When you look at the summary of the fund it tells you that it’s for retirement dates between 2043 and 2047. Perfect!

What’s Inside A Target Date Fund?

A target date fund is what is known as a fund of funds. That means that a target date mutual fund holds other mutual funds inside of it. Exactly what they hold depends on the fund provider but usually it’s a combination of US stocks, US bonds, International Stocks and US Bonds.

Here’s an example of the Vanguard 2045 target fund which holds the Vanguard version of their funds for each of those four major areas. Note that all the funds inside are low cost index funds that each have a large number of holdings. This one is about 87% stocks, 13% bonds.

Target Date Fund Asset Allocation

We’ve established that target date funds are a fund of funds holding a wide variety of stocks and bonds. However, the amount of stocks and bonds that is appropriate for an investor changes over time.

When you have many years until retirement, it’s appropriate to hold more stocks and few bonds. As you get close to retirement and need to use the money, that allocation should grow more conservative with stocks decreasing and bonds increasing.

And, that’s exactly what a target date fund does automagically for you. You own a single fund and progressively over time the fund changes the asset allocation to be appropriate. This can be seen by looking at all the target date funds from 2065 to 2015.

If your retirement date is out in 2065 you’re 43 years from retirement and have a long time horizon. You’re generally focused on growth and not as worried about volatility so the fund is 90% stocks, 10% bonds. It stays that way until the funds get ~25 years from the retirement date.

From there we see each fund slowly decrease it’s stock allocation and increase it’s bond allocation. This hits a roughly 50/50 portfolio at your retirement and then finally bottoms out at a 30% stock, 70% bond / TIPS allocation.

Here’s a more detailed view of what each target date fund holds inside of it. It’s a bit biased towards US stocks and bonds but does include international stocks and bonds.

One other thing to note is that Vanguard does start to add in inflation protected securities as you approach and are in retirement. You see that show up in the 2025 -> 2015 target date funds in the orange blocks.

What Happens After Your Retirement Date?

Looking at the previous charts you can see that there is no 2005 or 2010 target date funds. What happens after you reach the target retirement date? As always, read up on the particular fund. See below for the details on the Vanguard 2015 target date fund.

Seven years after the target date fund has passed its retirement year, they merge the target date fund into the retirement income mutual fund which has a fixed allocation going forward. By that seven year point the two funds had the same asset allocation anyway so there’s no impact to the investor.

This is easy to see in chart form when looking at what the 2015 fund and the income fund hold. The fund manager has progressively changed the 2015 allocation over time so that the two are very close to holding the same things. In the next year the two funds will be merged and next year there will be no 2015 target date fund.

If you look at the details of your particular target date fund it should explain what happens over time.

Target Date Funds In The Accumulation Phase

Now that we’ve established what target date funds are and how they work, lets talk about the pros and cons of using them in the accumulation phase. Accumulation phase being the time when you’re still contributing to your investment accounts instead of drawing down on them.

Positive – Requires Little Investing Knowledge

A target date fund is about as simple as it gets when it comes to investing. You pick the date that you want to retire, select the right fund based on that date and set your investments to buy 100% of that one fund.

Positive – No Rebalancing Required

If your portfolio has multiple funds inside of it then you need to rebalance periodically to keep your desired asset allocation. This is not the case if you hold a single fund!

For example, if you want a 60% stock, 40% bond allocation holding a stock fund and bond fund then you need to rebalance periodically. Over time, that stock fund will likely grow and make your allocation 70% stock, 30% bonds. You would need to sell stocks and buy bonds to return to a 60% / 40% allocation.

In holding a target date fund exclusively there’s nothing to rebalance. You hold 100% of that target date fund. Within the target fund there’s a percentage held of each fund.

One job of the fund manager is to keep the fund holdings at the target percentages in as tax efficient manner as possible. They do all the buying and selling, you just hold the fund.

Positive – Great Diversification

Investing can be very volatile and diversification is key to making sure that you aren’t overly exposed to one particular country, or asset class. Buying one target date fund provides a massive amount of diversification.

All of Vanguards target date funds hold four main index funds and some add a fifth fund when close to retirement. Each of these index funds hold a lot of individual securities!

Here’s a list of what you get by buying a single Vanguard target date fund:

  • Vanguard Total Stock Market Index Fund – Owns 4,100 US stocks in large, medium and small capitalization companies.
  • Vanguard Total International Stock Index Fund – Owns 7,781 non-US stocks in the major developed and emerging markets.
  • Vanguard Total Bond Market II Index Fund – Owns 9,922 individual bonds invested in U.S. Treasury, investment-grade corporate, mortgage-backed, and asset-backed securities.
  • Vanguard Total International Bond II Index Fund – Owns 7,014 non-US investment grade bonds in the major developed and emerging markets.

That single target date fund purchase gives you diversification across 11,881 different stocks and 16,936 different bonds worldwide!

Positive – Low Fees

Target date funds are a mutual fund that holds other mutual funds inside of it. This is often referred to as a “fund of funds”. Most commonly, as is the case for Vanguard, the target date fund holds low cost index funds inside of it.

You can see that the 2060 target date fund holds four different index funds inside of it. Not only that, but it holds the institutional versions of the funds where possible which has even lower expense ratios.

The result? A very low expense ratio of 0.08% for a fund of funds. Said another way, it only costs you $80 per year per $100,000 invested to hold all these funds. Cheap!

You are paying a slight premium for the one fund solution. Here are the expense ratios for the individual funds that you could buy as a retail investor:

  • VTSAX – Total US stock market index – 0.04%
  • VTIAX – Total International stock market index – 0.11%
  • VBTLX – Total US bond market index – 0.05%
  • VTABX – Total International Bond Market Index – 0.11%

If you held the 2060 target date fund percentages as individual funds you would pay a 0.069% expense ratio. Said another way you’re paying an extra $11/yr on $100,000 invested to own the target date fund instead of the individual investments (ignoring tax impacts).

Negative – Doesn’t Consider Your Risk Tolerance

The downside to many convenient, simplified solutions is that they don’t consider your unique situation. In the case of risk, target date funds have a certain asset allocation by age and don’t consider your personal risk tolerance.

For target date funds targeting people that are 25+ years from retirement, they are going to be aggressive with a 90% stock, 10% bond allocation.

But, can YOU handle the level of risk and volatility that comes with that asset allocation? Everyone is different. A 25 year old could take the Vanguard investor questionnaire and only be able to handle a 60/40 portfolio based on the results.

If they choose the target date fund based on the retirement date and it’s too aggressive they could become scared and sell during a market downturn. The 90/10 portfolio might be too much risk for THEM.

Negative – Tax Consequences If Held In A Taxable Account

Automatic allocation adjustment by age is great but it doesn’t come without a cost: taxes. This adjustment happens very slowly and over time but it’s usually unavoidable to sell one asset to buy another without paying capital gains taxes at some point.

The fund manager will do their best to minimize the taxes but they won’t be avoidable over the long term. This is really true of any portfolio in a taxable account where you will change the asset allocation as you approach retirement.

For example, here is the taxation on the Vanguard 2045 fund through the first five months of 2022. The realized gains are 0.68% of Net Asset Value (NAV).

If you had $1M invested and these were the gains for the year then:

Capital Gain = $1M * 0.0068 (0.68%) = $6,800.

If these were all long term capital gains (LTCG) and you were in the 15% LTCG bracket then you would pay:

Taxes due = $6,800 * 15% = $1,020 or 0.1% of your investment amount.

Since it’s ideal to be able to control our taxation it’s preferrable to hold target date funds in a tax advantaged retirement account (401k, 403b, 457, TSP, IRA, Roth). In that case no taxes are generated by the selling activity an you don’t have to worry about taxation until you withdraw money.

Target Date Funds Approaching And In Retirement (Drawdown)

As much as we’d like the retirement drawdown phase to be as simple as the accumulation phase, it’s just not. Here are some things to consider with target date funds in the retirement drawdown phase of life. This is the phase where we are actively living off of our money and need to sell retirement assets.

Positives That Don’t Change In The Drawdown Phase

There are some positive aspects of target date funds that don’t change in the drawdown phase. These are as follows:

  • Still doesn’t require a lot of investing knowledge
  • Still no rebalancing required
  • Great diversification
  • Low fees

Possible Negatives In The Drawdown Phase

As you could have guessed, it’s not all sunshine and rainbows when it comes to target date funds in the drawdown phase. There are more moving parts and the simplicity that was so attractive in the accumulation phase needs to be managed in the drawdown phase.

In the drawdown phase target date funds limit your options and may require special adjustments based on your personal situation and goals.

Negative – Can’t Set Your Asset Allocation Near Retirement

The largest sequence of return we risk we face is on the day we retire. Our assets are the largest and a market drop on that day could have a very substantial impact.

Target date funds do aim to get you towards a 50/50 allocation by your retirement (including some TIPS).

However, you don’t have control of exactly which assets you hold and in what percentages.

You can artificially alter this by selling the target date fund and buying a different one. For example, if your retirement date was 2025 then selling that and buying a 2040 fund would be change you from a 57/43 allocation to a more aggressive 80/20 allocation.

If your retirement date was 2025 then selling that and buying a 2020 fund would be change you from a 57/43 allocation to a more conservative 45/55 allocation.

Selling in a taxable account would create taxable events, though, so that’s not a great option if held there.

Obviously there’s also no ability to own something completely different than what’s in a target date fund. You can’t avoid holding corporate bonds by having a government bond fund instead of a total bond market fund.

Negative – No Ability To Tax Loss Harvest

If you are holding a separate stock and bond funds in a taxable account you have the ability to sell them during a downturn and buy different funds to realize a capital loss. If holding a target date fund the fund will rebalance but will not change investments to realize a loss.

Negative – Doesn’t Consider Legacy Goals

The asset allocation for a pot of money needs to align with the timeline and purpose of that money. If 2025 is your retirement date and you choose the corresponding target date fund then it’s going to adjust the asset allocation as if you need the money in 2025.

However, what if you never intend to use that money? If that money is for inheritance and generational wealth then you don’t need the money in 2025. Keep it in a 2025 fund and your asset allocation will become far too conservative for those legacy goals. You’d be better off with a fixed asset allocation that wouldn’t change over time on you.

Negative? – No Ability To Sell Specifics Assets

The simplicity of target date funds means that it’s all or nothing with a fund of funds. You can only sell shares of the entire fund which sells all the stocks and bonds inside of it.

Here’s an example.

Your $1M worth of target date funds is holding a 50/50 stock/bond allocation at the time ($500k/$500k). That $500k of stock drops 50% to $250k with a bear market and the bonds go up $50k to $550k. The fund is going to rebalance internally to $400k stock, $400k bonds. Selling the fund shares will then sell both stock and bonds in proportion to give you your money.

If the money was held as separate stock and bond funds you could opt to sell just the bond fund and leave the equities alone to recover. I’m not sure if this would have an appreciable impact on taxation or performance but I generally prefer more control over less.

Target Date Fund Suggestions

In summary, target date funds are great option for new investors and investors that value simplicity over control. Here are some suggestions for how to most effectively implement target date funds if they’re your investment of choice.

Stick To Target Date Funds Inside Of Retirement Accounts (401k, IRA, Roth versions)

Forced taxable events due to shifting asset allocations over time is probably the biggest downside to target date funds. By holding them only in retirement accounts then you shield yourself from taxable events. Additionally, it makes it easy to “graduate” to an asset allocation using individual funds in the future without causing taxable events.

Compare Your Risk Tolerance With A Target Date Fund Before Investing

One of the worst outcomes for a new investor is to lose more money than they can handle and be scared away from investing forever. It’s important to take a risk tolerance questionnaire like the Vanguard investor questionnaire and then compare the results with the recommended target date fund.

If the questionnaire recommends a 70/30 maximum allocation then a target date fund that invests with a 90/10 allocation might be too much risk. If a bear market hits those losses could be more than you can handle. In that situation you may be better off replicating a target date fund but using percentages that align with your personal risk tolerance.

Avoid Target Date Fund For Non-Retirement Goals

An important feature of target date funds is that they automatically adjust the asset allocation over time towards a retirement date. If the goal of the money is not actually retirement then the fund allocation might not align well with the goals that you have such as inheritance.

A better option in those situations might be to choose a fixed asset allocation of 2-3 index mutual funds based on that goal and your risk tolerance.

Action Steps:

  • Look up the details of your target date fund. What does it hold? What percentage of it is in stocks and bonds? What is the expense ratio? If > 0.5% then you might want to look for individual funds instead.
  • If you aren’t sure how much risk you can handle, consider taking an investment questionnaire. This is the MAX risk you can handle. Make sure that the target date fund asset allocation isn’t more aggressive (high percentage of stocks) than what the questionnaire said.
  • Check what accounts are holding your target date funds. Are you holding them in a brokerage account? If so, think about whether you’d like to keep doing that going forward. Keep an eye on the taxes you pay each year. Decide if you want to keep using them or replicate a target fund using individual index funds instead.

Have financial questions that you need help with? I’m opening up my mailbox to answer questions! I will keep all submitters anonymous and will post up answers on the blog for the benefit of everyone. To submit questions please e-mail me @ contact@managingFI.com.

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Investing

How Risky Are Stablecoins? 5 Risks To Consider

Risks of Stablecoins

BLUF: Stablecoins are attractive for their high interest rates and greater price stability but they aren’t risk free. It’s important to understand the risks before you decide how much to invest.

I actually started writing this article 3 months ago in mid-February. I had personally been on a journey of exploring the crypto space which including building up 1% of our portfolio across Bitcoin, Ethereum and the GUSD stablecoin.

At the end of 2021 I did a classic rookie mistake of letting FOMO (fear of missing out) drive me faster into an investment that I didn’t fully understand. Buying Bitcoin and Ethereum with new investment money was an okay decision. However, at the time I also moved our entire travel fund and part of our emergency fund into GUSD – the Gemini stablecoin.

This article is going to go into the details of stablecoins, yes. But the discussion about understanding and assessing the risks is more broadly applicable to more than just stablecoins. Assessing risks and then making decisions is a lifelong practice that can have large impacts on our lives.

I’m not here trying to scare you, but rather educate you. Investing is about taking on the right amount of risk based on your goals, plan and personality. Lets get into what stablecoins are and what risks exist when investing in them.

What is a stablecoin?

They’re a cryptocurrency that’s pegged 1:1 against another asset. Most commonly this is pegged against a FIAT currency like the USD.

An example of Gemini’s Dollar (GUSD), the stablecoin that I hold, in relation to the US dollar. Because the scale is so tight it seems volatile but the price most of the time is 1.00 +/- 1 cent.

Three Main Types Of Stablecoins

There are three main types of stable coins listed in order of most to least stable.

  • Fiat-backed – stablecoins that hold reserves of the currency that it’s pegged to in order to back it.
  • Crypto-backed – stablecoins that is backed (also called collateralized) by cryptocurrencies that are held in reserved.
  • Algorithmic – These use algorithms the regulate supply and demand in order to maintain the peg. They’re usually two or more token systems where one taken is a stablecoin and the second tokens price can freely fluctuate in the market.

Here’s a list of some popular stablecoins.

Stablecoin (Symbol) – Type

  • Tether (USDT) – Fiat-backed
  • Gemini USD (GUSD) – Fiat-backed
  • Circle US Coin (USDC) – Fiat-backed
  • Dai (DAI) – Crypto-backed
  • Terra USD (UST) – Algorithmic

How Does A Stablecoin Maintain Its Peg?

In a word – trust. All the biggest stablecoins are collateralized which means that they’re back by assets. Investors buy stablecoins with the understanding that their money will be used to purchase other reliable assets like US treasuries, money market funds or short term bonds. That gives them confidence that when they want to exchange those stablecoins back to FIAT currency, they’ll be able to do it.

The algorithmic stablecoins are either partially collateralized with another crypto token or non-collateralized. In theory these work by the algorithm acting like a central bank. It holds the peg by minting more coins when there’s high buying pressure to keep the price from rising. Burns coins when there’s a lot of selling pressure to keep the price from falling.

These are quite complicated and so far have not proven to hold up during volatile situations. The most recent implosion was the token Luna which worked in conjunction with Terra UST to maintain that stablecoin. UST couldn’t maintain its peg and Luna went into a death spiral in May 2022 trying to keep the peg. It never recovered.

Terra LUNA – The token associated with UST. From $80/coin to $.00025 in less than a week. Ouch

What Is The Utility Of Stablecoin?

Being stable!

In the cryto space, price volatility is the norm. Here’s an example of price volatility for Bitcoin, the largest coin in the world. This is over a WEEK. 5-10% changes in price over a day are not unusual.

Price volatility is okay for an investment that you plan to hold, but not money where price stability is desired. Here are a few situations where stablecoins prove to be a useful tool

A Tool To Combat Unstable FIAT Currencies

In the US we take for granted that the US dollar is so stable in value. A dollar in your Friday paycheck isn’t going to change in value by the time you go to the grocery store on Sunday. This isn’t the case in other countries. Venezuela’s hyperinflation was so bad that some stores removed price labels since the price was changing daily from the currency being devalued.

https://worldpopulationreview.com/country-rankings/inflation-rate-by-country

In countries with unstable currencies, stablecoins are one way for people to move their unstable FIAT currency into something that isn’t impacted by inflation like their native currency. It’s also a way to cheaply send money to relatives in other countries.

Providing Liquidity In Crypto Markets

Provides liquidity to crypto markets. If you look at the 24 hour trading volume, stablecoins dominate the market with Tether easily number #1. That should not be surprising since it also dominates in the circulating supply with $78B Tether coins out there.

If you look at the most popular coin in marketcap and volume, Bitcoin, you can see the most popular trading pairs and their volume. Stablecoins, and more specifically Tether, are the highest volume trading pairs with Bitcoin.

The Rewards

Before getting into risks, lets acknowledge why stablecoins are getting so much attention. High interest rates! And when I say high, I mean astronomical compared to anything resembling a bank account. Here’s an example of some of the highest rates being touted.

Greed drives a lot of human behavior and it’s hard to ignore something offering such high returns compared with the < 1% that most HYSA and CD’s are offering in May of 2022. We may not know much about how they can offer such good returns but our minds can justify a lot when there’s money to be made.

And this is the allure of stablecoins. You’ve found the nirvana of investing: high returns with low risk. Or have you?

The Difficulty In Assessing Risk

I’m sorry to burst your bubble, but like most things in investing and life, there is no free lunch. There’s no such thing high returns with low risk. You see, if there was, everyone would do it and the returns would drop. What I see is the “stable” term being misinterpreted.

Stablecoins are only price stable. Price stability is being mistaken by many to mean “safe” and “low risk.”

In my world of project management, there are two components to assessing a risk: the probability of the risk occurring and the magnitude of the impact if the risk occurs. We want to avoid or mitigate risks that are both high probability and high impact.

For example, building a house in a common flood zone. There’s a high probability of the flooding happening because there’s an established history of it based on the land. If the flooding does happen there’s a high impact in that the financial cost to repair or replace the house is great. That’s why flood insurance can be very expensive if you live in a flood zone.

That’s great to understand about risk, but that only helps if you can accurately assess the probability AND impact of a risk. With a company that often comes down to the reputation of the people running it, what they tell us and the information that they publish.

Bernie Madoff was a legitimate, trusted wall street businessman for years before he started his ponzi scheme that tricked so many. Many professional investors were invested in Madoff for years without realizing it was a fraud.

Enron was formed from two legitimate energy companies that existed for decades. Then internally some bad actors started committing accounting fraud over many years imploding the company surprising many. That fraud also flew under the radar for many years despite being a public company with required quarterly accounting reports.

I’m not trying to say that stablecoins are fraudulent. I’m trying to say that it can be very hard to assess the risk of things that look like they’re working well on the outside. Some investments can very abruptly flip from the “all is well” state to losing a lot of money.

5 Risks Of Investing In Stablecoins

Given that backdrop of information on stablecoins and risk, lets talk about 5 risks that exist in the use of stablecoins.

Stablecoins Losing Their Peg

One incorrect risk assessment is perceiving a stablecoin held on a crypto exchange with a similar level of stability, safety and trust as a savings account held at a bank. After all, its stable!

However, stability is the goal, not the guarantee. We certainly saw that with the stablecoin UST (now called USTC) losing it’s $1.00 peg. It now trades for $0.02 on the dollar so you’ve lost 98% of your stablecoin investment.

As much as our brains want to think of stablecoins as cash with a set value, they’re investments. There are risks being taken behind the scenes with the money that you use to buy stablecoins in order to provide the high published interest rates.

The systems that are in place to maintain that peg are not perfect and many have never been stressed to see how hey will hold up. Algorithmic stablecoins like UST so far have proved to be the highest risk to failing. And when it happens, it’s ugly.

No Insurance Against Loss (FDIC / SIPC)

Cash held in a regulated bank gets FDIC insurance to protect a depositor for up to $250,000 in the event that the bank goes out of business. The federal government provides that backstop to avoid bank runs that happen when people lose faith in a bank and fear that they won’t be able to get their money back.

Investments held in a financial institution that is an SIPC member company are protected in the event that the company declares bankruptcy. It protects up to $500,000 in investments including up to $250,000 in cash.

Two more recent examples of this was the Lehman Brother bankruptcy in 2008 and the Madoff Ponzi scheme. Because both of these were SIPC member institutions the SIPC stepped in and was able to help protect investor accounts and try to make them whole.

Source: SIPC History
Source: SIPC History

It’s important to recognize that SIPC does NOT insure you against the loss of capital because your investments decrease in value. It’s only against bankruptcy of the member company.

At the time of writing there aren’t any crypto only exchanges that are SIPC insured. Gemini, for example, has FDIC insurance on cash it holds but no SIPC insurance. And they are one of the standout companies in the space in my opinion when it comes to being reputable and lower risk.

Counterparty Risk – The Stablecoin Company

It’s important to recognize that all these stablecoins are issued by private companies. The companies created this “currency” and for that currency to have value and exist, the company that created the stablecoin needs to be able to take those stablecoins back at any time and give you back FIAT currency in exchange.

Counterparty risk is the risk that the other party in a transaction or investment isn’t able to hold up their end of the deal. In the case of the stablecoin this could mean maintain the peg as previously discussed. It could mean that they can’t hand you back a dollar in exchange for each stablecoin that you have.

It’s easy to think of a stablecoin like any other currency. However, there’s a big difference between having the full economy of the US government standing behind the US dollar versus the having Tether Ltd. standing behind their Tether stablecoin USDT.

Tether Ltd. is a private company that has issued $72.5B (billion!) in stablecoins. That’s a lot of money and responsibility. Being an asset backed stablecoin they need to responsibly manage that money to ensure that it’s available for redemption when people want it.

Per their website this is how those reserves are held. Looks like a vast majority of it is held in very safe, secure investments like cash and US treasury bills

Commercial paper makes up a healthy percentage as well. Commercial paper is unsecured, short term debt that typically earns very little interest. 0.36% is the February 2022 interest rate for 3 month, AA rated commercial paper. If you buy up commercial paper from higher risk (lower rated) companies you’ll make a higher return but have a higher risk of default.

https://ycharts.com/indicators/3_month_aa_financial_commercial_paper_rate

However, it is important to recognize that this is all “self reported” information. There have been attestations done but no true audits. Or, as they call them “assurance opinions”. In other words, nobody has gone through and looked at all the accounts where Tether says that these reserves are held in to verify that everything is as they say it is.

I’m not saying that there’s a problem here, but the fact that they’ve never been audited and refuse to be properly audited is a red flag to me. Being that they are the #3 most valuable crypto asset in the world I sure hope that they are properly managing this reserve money.

That’s the counterparty risk that you accept with Tether. If any kind of fraud or mismanagement did occur and they couldn’t redeem your USDT for FIAT currency then the stablecoin would plummet in value.

Regulatory risk

The cryptocurrency industry is very much in it’s infancy. It has gotten so big, so quickly that it’s just starting to get more attention from governments. With so much economic money becoming intertwined with crypto, the risk goes up of a crypto collapse impacting businesses and countries goes up. Nobody wants a financial crisis like 2008 again.

In response, some governments like China have banned cryptocurrency. In the US, the SEC is looking at crypto companies much more closely and handing out fines if they aren’t complying with the rules. The SEC fined BlockFI $100M because of violations.

The point is that regulation is coming and that’s a good thing. It will help to keep peoples money safe by increasing company transparency and holding them to risk management standards. However, regulation could force some companies out of business due to fines or being unable to comply.

By chance I end up with Gemini because New York has very tough compliance rules and Coinbase was the only other option. However, in hindsight, I’m happy about that because I think the probability is lower that Gemini could do something shady and get away with it.

Hacking Risk

Police: Why do you rob banks?

Willie: Because that’s where the money is.

Willie Sutton, bank robber

One downside with the crypto space is that its really a hackers dream. No more dealing with malware and trying to extort money from people to get their data back. With crypto, there are a hundred different “banks” full of crypto from which they can steal directly.

I had someone who was able to log into my Gemini account in the middle of the night and the only thing that saved me was the I had two factor authentication turned on. Fortunately they weren’t smart enough to get around that. However, people can even spoof phones now to bypass that.

There are so many startup crypto exchanges and projects that there is money floating everywhere in cyber space. These smaller companies don’t have the budgets to secure your account like more established companies. If you crypto is stolen you’re often out of luck.

If you counter this risk by holding your assets off the exchanges in a cold wallet then there’s the risk of a seed phrase being lost and the crypto not being recoverable. This article from last year estimated that 20% of all bitcoin seems to be lost or stuck in hardware wallets.

What Am I Doing?

In February 2022 I reversed course and pulled most of that emergency fund money and all of the travel fund back out and into our HYSA. I decided that I was most comfortable with treating stablecoins as an investment and only putting what I was willing to lose in them.

I do feel more confident with my money held in Gemini. However, it’s going to take more time and some more regulation in the industry for me to be comfortable putting money that I can’t lose into them.

I keep a modest crypto portfolio of 1% of my total portfolio. Of that, it’s roughly 55% bitcoin, 25% Ethereum, 20% GUSD stablecoins.

Are Stablecoins Worth The Risk?

Like all investment decisions, that’s really up to you to decide based on your situation, risk tolerance and what you can afford to use. I think they’re an interesting investment option and can be one of the less risky options in the crypto space.

However, personally, I wouldn’t park large sums of cash that you can’t afford to lose. My opinion could certainly change over time as the industry matures but it’s still the wild wild west out there in many areas.

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Investing

Are Passive Mutual Funds Superior To Active?

Passive Mutual Funds Superior To Active

BLUF: On average, active mutual funds largely underperform their benchmarks, have much higher fees and are less diversified than passive mutual funds. If held in a taxable account they often generate lower returns after taxes than passive mutual funds that follow the benchmarks.

Everyone wants their portfolios to do well. Many of us work a job or run a business saving and investing for the future. We hope that those investments will grow for us in the future to fund our goals be it security, retirement, legacy (prestige, inheritance or generational wealth), charitable or some combination of those.

In order for investments to grow, they need to perform. How they perform over a lifetime will have a huge impact on reaching our goals. Over the long term, just a 1% difference in the performance of your portfolio can compound to some very large differences.

Take a 30 year old that starts with zero savings. If they save $1,000 a month for 35 years and get a return of 6% per year they’ll have $1.4M at age 65.

Take the same 30 year old but this time they get a return of 7%. That 1% of additional return compounds to $1.8M or 25% more.

Due to this big return difference, people are constantly searching for the “best” place to invest their money with best usually equating to overall return performance. One important choice is whether to invest in a passive or an active mutual fund.

In this post we’ll explore what passive and active mutual funds are, the key differences between them and some things to consider when choosing. For simplicity I’m going to talk about mutual funds but the same points apply to passive and active ETFs.

If you don’t know much about mutual funds, ETF’s or index funds then I suggest you read this deep dive into the basics of each.

Passive Mutual Funds

Passive mutual funds are are seeking to replicate the performance of an index, a sector or some other benchmark. These funds aren’t trying to beat the market. The fund manager doesn’t have a choice of what to invest in. They invest in the exact securities required to replicate that index or benchmarch.

Stock index mutual funds are all considered passive mutual funds and are some of the most popular investments out there. The funds only change the stocks that they hold when the benchmark index removes or adds companies from it.

For example, if an S&P500 index kicks a company out then the mutual fund tracking that index sells all shares of the booted company and buys the shares of the company that replaces it.

A popular example of a passive mutual fund is the Vanguard VTSAX total stock market index mutual fund. You can see that its investment strategy is to track the CRSP US total market index. That’s the benchmark that VTSAX does it’s best to replicate.

Passive Mutual Fund Investment Strategy Example: Vanguards VTSAX Total Market Index Mutual Fund

Active Mutual Funds

Active mutual funds on the other hand are active because a fund manager isn’t trying to track some index benchmark. Each fund has an objective and a strategy that they are using to meet that objective.

The fund manager is actively buying and selling securities in order to meet that objective. You have a human at the helm with supporting analysts actively making decisions about what the fund should hold and when to change what it’s holding.

For example, here is the Fidelity Select Energy Portfolio mutual fund FSENX.

You can see from it’s strategy and the name that it’s trying to grow your money by investing in stock of companies in the energy sector. There is no index to follow. It’s completely up to the fund managers discretion how they choose to implement that strategy.

Passive Mutual Funds vs. Active Mutual Funds

There are a few very important areas where passive mutual funds and active mutual funds function very differently. Since these areas can impact your overall investment returns it’s important to be aware of them.

Performance: The Benchmark Vs. Trying To Beat The Benchmark

We started the article talking about performance being one of the things that investors care about most. If you want the best performance, should you buy passive funds or active?

Passive Fund Performance

In the case of passive mutual funds, they’re often serving as a benchmark to beat. They represent an entire part of the sector, market or an index and replicate the standard that active funds are trying to beat.

Here’s an example of a favorite Vanguard VTSAX total US market fund. The blue is VTSAX and the yellow is the index that it’s trying to implement and replicate.

VTSAX isn’t trying to beat any benchmark. It’s trying to replicate the benchmark. The expectation of the fund manager is that it tracks the index as closely as possible. As you can see, it does a really good job of it. It’s implementing that index (like many passive mutual funds) with a buy and hold strategy.

Active Fund Performance

Active mutual funds, on the other hand, are attempting to exceed the performance of the boring old indices or sectors. A fund manager is being paid for their individual expertise in implementing a general strategy but they have a lot more leeway as to how they want to implement the strategy.

The problem is that most active funds can’t actually beat their benchmarks. One company, SPG global, has a scorecard to measure the performance of active funds compared to their benchmarks over time.

The scorecard that they use to measure active mutual funds against their benchmarks over the last 20 years has showed a couple of distinct themes:

Actively Managed Mutual Funds Underperform Their Benchmarks

One is that actively managed funds have historically tended to underperform their benchmarks over short- and long-term periods. This has tended to hold true (with exceptions) across countries and regions.

SPG Global

In the US, 83% of actively managed large cap mutual funds underperform the S&P500 over a 10 year time horizon.

Source: https://www.spglobal.com/spdji/en/research-insights/spiva/

If you look across the board at a variety of different fund categories it’s a bloodbath. Even within the first year, way more than 62-98% of funds underperform across a range of market capitalizations.

Source: https://www.spglobal.com/spdji/en/research-insights/spiva/
Active Mutual Funds Don’t Consistently Outperform

Another recurring theme is that even when a majority of actively managed funds in a category have outperformed the benchmark over one time period, they have usually failed to outperform over multiple periods

SPG Global

The problem here is that to chase performance, successful actively managed mutual funds implement a strategy that works by picking the “hot” thing. That works while the hot thing stays hot, but it’s unlikely to stay that way over the long term. As we know, markets move in cycles and todays top performing area is usually tomorrows dog.

Want to see this in action? Here’s a list of the top performing active mutual funds available at Fidelity over the last 10 years.

What do you see? The red boxes show that most of the top performers are large cap growth associated funds since growth stocks have been crushing it. However, 2022 has been a different story as you can see in the blue box and those same funds are getting crushed now.

Cost Of Ownership

The investing world is full of sneaky ways to take your money. You rarely have to write someone a check for them to charge you fees because they already have your money. Before investing in something it’s important to understand the costs involved in buying, holding and selling that investment.

Fees

Active mutual funds often employ a variety of different investing strategies other than just buy and hold. Trading more frequently, buying investments that having higher trading expenses and buying things that aren’t even available to the average invest all have cost.

Add onto that a professional fund manager who gets paid a lot and the result is that the investment fees that you pay to own the mutual fund are much higher than a passive mutual fund.

That fee, called an expense ratio, if a percentage that you pay every year, to hold that mutual fund. Here is a passive and active mutual fund example – VTSAX with a 0.04% expense ratio.

And here is an active mutual fund example that invests in well established medium to large cap US growth stocks. It has a 0.79% expense ratio.

What are the fees on each of these investments? If you were to hold $100,000 of each of these funds, you’ll be charged the following:

VTSAX (passive example, 0.03% expense ratio)= $100,000 * 0.0003 = $30/year.

FCNTX (active example, 0.79% expense ratio) = $100,000 * 0.0079 = $790/year.

That means that if you’re looking for the best performance, that blue chip fund needs to outperform VTSAX by 0.76% each year just to break even with it. If the blue chip fund under performs, you’re still paying that 0.79%.

Turnover Rate – Impacts Taxation Potential

american dollar bills and vintage light box with inscription
Photo by Karolina Grabowska on Pexels.com

Actively managed funds tend to trade inside of them more often to meet their goals. Just like ordinary investors, those funds realize taxable gains and losses when they sell investments.

Those gains and losses are passed along to the fund holders so this metric is important if you hold a mutual fund within a taxable brokerage account. This issue doesn’t apply if you hold the funds with a tax advantaged retirement account like a 401k, 403b, TSP or IRA.

Turnover rate is a metric of how much buying and selling a fund does. The higher the number, the more buying and selling that occurs and more potential for higher expenses and also the flow down of gains and losses to you at tax time. The lower the number, the better from a potential for taxation perspective. An example below for FLGEX, a large cap growth fund.

The easiest place to see the impact of this trading on taxes is in the performance area. Here you can see the returns before and after the taxes associated with the sale of fund shares. In the 5 year column you can see that about 2% / year on average is lost to taxes.

Trading Fees

This might seem crazy in todays world of no trading fees for many stocks and bonds but you have to watch out for trading fees with mutual funds. It’s not unusual for a broker to charge a sizable fee for EACH transaction in a mutual fund that is owned by another company.

For example, here’s a blurb right on Fidelity’s website. $50-$75 PER TRANSATION for some mutual funds.

Go into one of these funds and there it is. $49.95 per transaction. That means $49.95 each time you buy the fund. $49.95 each time you sell the fund. Even if you were to buy or sell $100,000 at a time, that’s adding a 0.05% fee to every transaction.

Loads (sales charge)

One big active mutual fund cost to watch out for are funds with loads. A load is a percentage fee that the fund charges to buy into that fund. This is a sales fee where they take your money and you’re never getting it back.

Here’s an example using a particularly awful active mutual fund that you can buy through fidelity.

This fund charges you 5.75% as a sales charge when you buy it. That means that if you want to buy $100,000 of this fund that they’re going to pocket $5,750 of your money as a sales charge and give you $94,250 worth of the mutual fund.

Then, to make it more awful, there’s a deferred sales charge when you sell. That’s right, they take more money when you sell AND it’s based off of the original purchase price. It doesn’t matter if the fund has gone down. Back to our example, you purchased $100,000 so this deferred load will charge you $1,000 when you go to sell it. Even if the fund value had dropped to $30,000.

Thankfully mutual funds with loads have become far less common but they still exist. Watch out for them and in general, stay away! Stick to looking for “no load” mutual funds which don’t charge this sales fee.

Diversification

Passive mutual funds are diversified in that they own the entirety of whatever benchmark that they’re trying to replicate. You own everything in a particular sector, market, index or industry.

Active mutual funds, however, are inherently less diversified. To beat the benchmark, they’re trying to only own the biggest winners in some market segment and not buy the losers.

In practice, though, to do that can mean that the biggest performing active funds are highly concentrated in what they own. Some funds may have rules about how much of any one investment that they can own but others may not.

Lets take that Baron Partners Fund as an example. In my Fidelity search of large cap US funds that was number one in 10 year performance. It’s actually 6% higher in performance any any other fund in 10 year performance.

WOW! They must be doing something amazing. Lets look more closely at the fund starting with their strategy. Oye, they’re using leverage by borrowing up to 33% of the total value of the fund. Well, that sounds a bit risky.

What are they buying with that borrowed money? Holy crap. They own a total of 32 investments with 54% of the fund holding Tesla stock! Did I mention that this fund has a 1.36% expense ratio so you’re paying a nice fee to hold a fund that’s heavily concentrated in Tesla.

This might be an outlier but it’s just one example of how actively managed funds can do some pretty extreme things to outperform. If Tesla tanks this fund will crash. If it tanks badly enough it could get margin called and blow up.

Are Passive Mutual Funds Superior To Active Mutual Funds?

Based on the data presented I sure think so. On average, active mutual funds largely underperform their benchmarks, have much higher fees and are less diversified than passive mutual funds. If held in a taxable account an active fund is going to generate more taxes making it even harder to compete on an after tax basis.

The odds of an actively managed mutual fund beating its benchmark over 10 years is very low, let alone over a 20, 30, 40 or 50 year investors lifetime. The odds of you then picking one of those unicorn funds AND that fund being open to a retail investor are low. What is for certain is that you’re going to pay higher fees, will be less diversified and will have greater tax liability in a brokerage account.

Is it possible for an active mutual fund to outperform, net of fees, after taxes, over the long term? Highly unlikely. Even iconic funds like Fidelities Magellan fund has underperformed over very long time horizons. Here is a comparison between that fund and the S&P500 from 1994 to 2022.

What Do We Invest In?

We’re 100% invested in passive mutual funds and ETFs with a vast majority of it in a three fund portfolio: Total US stock market, total international stock market ex-US, total US bond market. Here’s an example from my Roth IRA.

I try and stay open minded to the possibility that there could be a place for an active fund as a part of our portfolio in the future but I haven’t found a compelling reason yet.

Do you invest in any actively managed mutual funds? If so, which ones and why? Comment down below.

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Categories
Financial Updates General FI

2022 Q1 FI Progress, Inflation and Breaking My Market Addiction

I’m a big fan of experimenting and trying new things so I’m going to try something new for this latest post. Earlier this year I became more transparent on the blog in posting how we crossed over the 7 figure investment account number and saving over $100,000 last year.

Recently, I wrote about keeping a cool head and on track when the markets start getting volatile (in the downward direction). I’ve noticed a lot of people struggling in this aspect. New investors worried about losing money in the market and stressed by their account balances going down even when they’re actively adding to them!

This post is going to be the start of quarterly updates to our financial situation including the change in account balances. Hopefully it gives some people comfort to know that they’re not alone and the encouragement to stay the course investing in their future.

I’m also going to use this post to talk about some additional small topics. Updates on topics that I’ve previously written about and have taken action on. Things going on in the financial world. Things that are on my financial mind.

2022 Q1 Financial Update:

In my article about the retirement tax triangle, I talked about the benefits of investing in all three of the retirement account types: taxable, tax free and tax deferred. I “eat my own cooking” so to speak, and actually do track my accounts in that way. You’ll see the breakdown of our finances into those account types.

Q1 Total Investment Account (-$37,100) Value Changes:

I like to start at the high level and go deeper into detail so here’s the overall change in value. Current investments is all our invested assets.

Net worth includes our house but assumes that it’s sold. Why? I haven’t written about this yet but right now we’re aspiring to one day to sell everything and tour the US in an RV for potential relocation spots.

Q1 Account Contribution Summary (+$41,985):

  • Taxable (+$16,700)
  • Tax Free (+$4,754)
  • Tax Deferred (+$15,585)

In Q1 our overall investment accounts were -$37,000. Ouch. And that’s AFTER contributing $42,000 into them. In other words a net -$79,000. That’s more than the average US household makes in a year.

That $42k was aided significantly by an annual bonus received in March so that won’t be the norm for Q2-Q4.

That’s how it goes sometimes with being an investor. Losing money, even if on paper, generates pain and emotions. Those can be pretty intense when you’re early in your investing career and not used to them.

I know it’s not what you want to hear, but you have to really experience that pain and control your emotions if you want to grow as an investor. You can’t learn about it in a book or from a story that someone tells you. You need to feel it yourself.

How do you stay the course when it feels like investing is just lighting dollar bills on fire? Look at history to remind you. The S&P500 has gone through periods of tough times but over the long haul, it has always had positive returns over 15+ year periods.

S&P500 historical chart from Macrotrends

Q1 Net Worth (-$17,800) Value Changes:

News flash – the housing market is still bananas. We own a very modest 1,500 square foot “starter home” in a moderate cost of living location. Our housing prices here in western NY state generally don’t boom or crash but they’re resumed their insanity since the start of 2022.

Our home value went up almost $18k and we paid down $3,200 of our mortgage. I had been overpaying more on the mortgage in Q1 but now that the market has had some more substantial drops will back off that. I’ll invest more in our taxable investment account instead. I ran the numbers on pre-paying my mortgage vs. invest in this article.

The Zillow Zestimate change over the last 3 months has been an $18,000 increase or over 10%! Crazy. Rising mortgage interest rates is really pushing people to try and get into a house is what I’m guessing.

At some point the increased mortgage rates will make buying at elevated prices unaffordable and I think prices will come back down to earth a bit. A 30 year mortgage at 6% has a monthly payment that’s about 40% higher than a mortgage at 3%.

Taxable Accounts Value Change (+$4,150):

Here are our contributions to these accounts this quarter.

Q1 Taxable Account Contributions: +$16,700

  • Brokerage – Added $5,500 to the account.
  • iBonds – Bought $11,500 between funds that had been sitting in cash and from new income.
  • Crypto – removed $5,300 from Stable coins to put back into HYSA’s for our travel fund and part of our emergency fund. Added $5,000 to BTC and ETH.

iBonds had been on my mind even before writing this detailed all about iBonds article. Mrs. MFI had some emergency fund cash sitting in a 0.01% savings account so we put that to work. We had more than enough EF cash if I were to lose my job so we were comfortable putting it into iBonds.

I decided to dial back the risk a little and take some of our sinking funds out of stable coins. I have a 75% written article on stable coins to discuss the level of risk there. They seem low risk in theory but just because you can’t see the risk, doesn’t mean that it isn’t there.

We contributed $16,700 and saw the overall taxable account values go up $4,150. Ouch.

Tax Free Accounts Value Change (+$4,754):

Q1 Tax Free Account Contributions: +$9,700

  • Cash – Removed $10k to buy iBonds. Added $5k back into the “cash” category from stable coins as a part of our travel fund and emergency fund.
  • Roth IRA – Added $12k. Executed back door contributions to max out both Roth accounts.
  • HSA – Added ~$1825 in contributions. Also moved $2k that was stuck in Mrs. MFIs HSA bank account. We’re both setup to max our HSA contribution for a combined total of $7,300 for the year.

In total we added about $9k to this category but it’s only up $4,700. Because our HSA’s are our retirement healthcare fund, we don’t need them for 25 years so they’re invested 100% in stock indices (VTI and VXUS). The

Tax Deferred Accounts Value Change (-$46,000):

One caveat to the tax deferred contributions. We are saving after tax dollars into the Mr. MFI 401k to perform a mega backdoor Roth contribution in 2022. That account will get more than $20,500 contributed to it but the after tax portion will get rolled out in November 2022.

Q1 Tax Deferred Account Contributions (+$15,585):

  • Mr. MFI 401k – $6,750 in my contributions. $3,710 in company contributions.
  • Mrs. MFI 401k – $5,125 in her contributions.

These accounts are a little heavier on bonds at a roughly 70% stock / 30% bond split. Both got hit hard and dropped in value.

Financial Topics On My Mind:

Breaking My Addiction To Watching Markets Daily:

In a recent article I talked about methods for avoiding investing mistakes. One key method was to stop watching the markets every day. I personally struggled with this one a lot.

I got into the habit when I was trading futures and Forex. Futures trade 24 hours a day from Sunday at 6pm EST to Friday at 6pm EST in my markets.

Determined to fix this, I’ve successfully stopped my daily watching and have now fallen back to looking at the market on the weekend when they’re closed.

Yes, I still have the urge to check during the week if I catch a piece of financial news. Yes, I’ve had a couple of slip ups. But, it’s a vast improvement from the 4-5 times a day that I was routinely looking at the market.

Roth 401k vs. Traditional 401k:

Mrs. MFI and I are both currently maxing out our 401k accounts with traditional 401k contributions. We both have the option to contribute some percentage as a 401k if we choose.

In my tax triangle article I noted that I was considering flipping over some or all of our contributions over to Roth since we were heavy in our traditional 401k accounts.

Account percentages in February 2022

Right now any contribution that I changed from traditional to Roth 401k would be taxed at 24% given our highest marginal tax bracket. We’re piling money into a Roth due to the mega backdoor but with $50k+ being contributed to our tax deferred accounts annually it won’t make up any ground.

My thinking at the time was that in 2026 the tax brackets will reset higher so better to take the tax hit now with a Roth 401k and in 2026 I could flip those back to t401k. I don’t like to do these types of changes without more analysis though so I’m staying the course for now.

I’ll do the analysis in a future article but I think we’ll have plenty of low income years between age 55 and 67/70 to draw down those tax deferred accounts while keeping our effective tax rate low.

Inflation, Interest Rates and Bonds:

Inflation. Everywhere you read in 2022 everyone is talking about inflation. They just released the April 2022 CPI report and it showed 8.5% annual inflation increase.

The stock market is going down so people don’t want to put money there. Interest rates are rising so intermediate term and long term bonds are getting crushed. People have discovered iBonds once again so they’re becoming very popular with a May 2022 annualized rate of 9.62% but they have low purchasing limits at $10k/person/year.

This period is indeed painful, but it will get better. The beauty of bond funds is that they constantly have bonds hitting maturity with new bonds being purchased at the new, higher interest rate. Over time, the yield to maturity will get higher and higher until interest rates level off and eventually drop.

If you need bonds for stability because of your risk tolerance and timeline, then hold bonds. Don’t let short term interest rates influence your asset allocation. Don’t let the interest rate risk tail wag the dog.

Taxable Account – Stay with Vanguard, Move to Fidelity, Move to M1 Finance with ETF’s

In my most recent article about mutual funds and ETFs, I contemplated the idea of moving to ETF’s to avoid the risk of taxes after the Vanguard target date fund incident of 2021. That kills my ability to automate my investments though with Vanguard since they’re pretty behind the times technology wise.

Since I only invest in passive index based mutual funds I think the risk is low of some special tax bomb event. Vanguard does let you flip from mutual funds to equivalent ETFs without selling your holdings.

So, the plan for me is to stay with mutual funds for now so I can keep auto-investing. When we get closer to switching from accumulation to drawing down I’ll likely migrate that account to ETFs and then move it to Fidelity for simplicity. We’ll likely collect all our funds there for ease of management.

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Mutual Funds vs. ETFs: Pick The Best One For You

BLUF: Mutual Funds and ETFs are the foundation of many portfolios. However, they do differ in tax treatment, ease of automation, liquidity, portability and fees. Educate yourself and choose the right tool for your situation.

No matter where you are on your investing journey you’ve likely heard the terms mutual fund and ETF before at some point. While on the surface these may seem like investing basics, it’s important to understand what each are, how they work, their strengths and their weaknesses.

Knowing this information allows us to decide which one makes the most sense in our individual investment situation. This includes understanding tax implications, ease of automation, portability, investment minimums and liquidity.

Basic Definitions – Fund, Index, Index Fund, Mutual Fund, Exchange Traded Fund (ETF)

Before we get into the technical weeks of mutual funds and ETFs, lets ground ourselves with what these building block terms mean.

What Is A Fund?

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Very simply, a fund is money that is pooled together for a specific reason. In investing this means investors pooling their money together to purchase some kind of investment where they hope to receive a return.

If you and your friends wanted to pool your money together and buy a rental property together that would technically be a fund.

We often hear this word used for a variety of different investment vehicles: index fund, mutual fund, exchange traded fund (ETF) and hedge fund.

What Is An Index?

An index in finance is a way to measure the performance of some basked of financial instruments. For average investors this usually means measuring a basket of securities like stocks or bonds.

An index isn’t an investment, it’s just a way to track a group of investible things to see how well they perform. For example, I could create the New York Stock Index that includes every publicly traded company that is headquartered in New York State. You can create an index for anything.

Two of the most famous stock indices in the US are the Dow Jones Industrial Average (DJIA) and the Standard & Poors 500 (S&P 500). They each have different rules and criteria for which companies qualify to be in the index. For example, the S&P 500 is the 500 large cap companies that meet the criteria of that index.

Indexes are created by companies and are most commonly used for two things:

  1. To create a performance benchmark that other investments or investors
  2. To create index funds that investors can invest directly in.

What Is An Index Fund?

An index is great, but you can’t buy an index. An index fund isn’t actually a financial instrument. It’s shorthand for either an index mutual fund or index exchange traded fund (ETF) which we’ll talk about shortly.

Mutual funds and ETFs are the real financial instruments that you can buy and sell. When people say index fund just know that they’re talking about either a mutual fund or ETF that lets them invest in an index.

For example, we previously mentioned the S&P500 index. Vanguards mutual fund that tracks the S&P500 is VFIAX.

They also have an ETF equivalent that tracks the same index.

What Is A Mutual Fund?

A mutual fund is a basket of stocks or bonds that are purchased by a professional manager using a pool of investor money. Mutual funds have been around since the 1920’s. The professional manager uses investor money to buy different assets based on the goal of that particular fund.

I’ll go into more specifics about mutual funds including their pros and cons when I talk about the similarities and differences with ETF’s.

What Is An Exchange Traded Fund (ETF)?

Similar to a mutual fund, an ETF is also a fund where a basket of stocks or bonds that are purchased by a professional manager using a pool of investor money. The differences lie in how they implement that fund with most of detail happening behind the scenes and unknown to the investor.

The first ever ETF was created in 1993 and was an S&P500 index ETF with the ticker SPY. So, these are a much more recent invention compared to the mutual fund. However, they’ve exploded in popularity for reasons that we’ll get into soon.

You can think of the mutual funds versus ETFs like the difference between your 401k and a taxable brokerage account. They both let you buy and sell investments but the rules around taxation, when and how the money can go in and out of the accounts are very different.

It’s not really important for us to know how the sausage is made behind the scenes. Just to know how ETFs are another type of fund with some distinct feature differences that we’ll get into now.

Mutual Fund and Exchange Traded Fund (ETF) – The Similarities

Normally I would describe each of these tradable securities separately in detail but each of these fund types has a lot of similarities to the average investor.

Assets Held:

Mutual funds and ETFs are capable of holding the same stocks, bonds, commodities and other alternative investments inside of them. An S&P500 mutual fund is going to hold the exact same 500 US companies inside of it as an ETF that tracks the S&P500 index.

Types Of Funds Available

All the major stock and bond indexes for both US and international are available in both mutual fund and ETF form. You can see many examples of this ability to hold the same thing in both mutual fund and ETF form in the Vanguard fund lineup.

Across the big 3 investment brokerage companies you can fortunately find similar stock and bond index options to build a great portfolio. Here are some helpful guides to show you which mutual fund and ETF options are available at these brokerages. Share them with your friends!

Cheat sheet for stock index funds:

Cheat sheet for bond index funds:

Actively managed funds that go into more exotic strategies and asset classes are also available in both types of funds as well.

Fidelity alone has 9,577 different mutual funds available with 9,165 of those being actively managed funds. The remaining 412 are index fund options. In other words, they’ve invented every possible way to try and get your money with the hope of superior returns.

Mutual Fund and Exchange Traded Fund (ETF) – The Differences

Despite how similar these fund types are, there are distinct difference in how they’re traded, taxed and handled on different brokerage platforms.

Liquidity

Liquidity describes how fast and easy it is to get into (buy) or out of (sell) an investment. Mutual funds one have one buy and sell price per day which is established after the market closes on 4pm EST, Monday – Friday.

You can’t buy or sell mutual funds in the middle of the trading day. If you submit an order for VTSAX, the total stock market mutual fund on Tuesday at 6pm, it will be executed on Wednesday after 4pm when the market closes.

That’s why a mutual fund chart looks like a bunch of dashes if you try to view it as a candlestick chart. Here is an example of that with VTSAX.

ETF’s on the other hand trade like stocks. You can buy and sell them at any time during the trading day (9:30am – 4pm EST are the normal exchange hours).

You can see this in the candlestick chart for the ETF VTI (ETF equivalent of VTSAX). Each day the prices fluctuate with the height of the candle showing the price movement for the day.

For that reason ETFs have a bit more liquidity. Generally this isn’t a big issue for a long term investor but if you have something time sensitive and need to sell investments that day then the ETF’s will buy you hours.

Tax Treatment

Mutual funds have more taxable events, especially capital gains and losses, that pass through to the holders of those mutual funds. This is important to know if you hold mutual funds in a taxable brokerage account.

The likelihood of substantial capital gains is very low with an index mutual fund but much more likely with actively managed mutual funds. That said, the massive tax debacle with Vanguard target date funds where people were hit with huge tax bills without any real gains highlights the tax risk.

It’s important to understand that mutual funds distribute capital gains for all people holding the fund near the end of the year. It’s entirely possible that you buy a mutual fund in August and are hit with capital gains distributions in December for gains that you never saw in your account.

ETF’s on the other hand generally don’t distribute capital gains or losses during normal circumstances. The capital gains stay within the fund and you realize those gains when you sell your appreciated ETF shares. No surprises.

In both mutual funds and ETF’s the dividends are passed through to the owner. They’re considered qualified dividends taxed at long term capital gains rates if you held the fund for at least 60 days. Otherwise they’re unqualified dividends and taxed at your ordinary income tax rate.

More info on ETF taxation here if you’re interested.

Investing Minimums

Mutual funds typically have a minimum amount of money that is required before you can invest in that fund. This is often in the low thousands of dollars. For example, the ever popular VTSAX has a minimum of $3,000 to invest in it.

However, ETFs are much more accessible. The investment minimum used to be the price of a single share. For example the ETF equivalent of VTSAX, VTI, is currently trading at $225/share.

However, these days almost all brokerages allow you to buy fractional shares. This often means that you can invest in these ETFs even if you have only $5 or $10!

Here’s an example of that buying VTI. I didn’t have $225 in my account for a full share but with my $150 I was able to buy 0.6667 shares.

Portability Of Investments

Portability of investments is talking about how easily you could move your account with investments from one brokerage to another. For retirement accounts this is a non-issue because you can sell assets without tax consequence and move the account in cash.

However, this is an important consideration for a taxable brokerage account since you can’t just sell your assets to cash without creating a huge tax event. The desired approach is to transfer the assets “in kind”. This means that you hold onto your shares and move them from Vanguard to Fidelity, for example.

With mutual funds, this can problematic. The receiving brokerage account must off the mutual fund that you want to move for them to let you move it. For example, Vanguard doesn’t offer Fidelities most popular FZROX total market fund because it competes with VTSAX. You wouldn’t be able to move those shares from a Fidelity taxable account directly to a Vanguard taxable account.

If they do let you buy another brokerages mutual funds, watch out for fees. Here is Fidelity charging $75 for a one time buy of Vanguards VTSAX. Yikes!

ETFs, however, are much more universally available across platforms. It might be an issue if you own very niche ETF’s but all the major index ETFs should be no issue. It becomes an easy thing to transfer assets in kind in the ETF world.

I’ve heard that Vanguard will let you convert your mutual funds to their ETF equivalent without tax consequence within a brokerage account. I’m thinking about doing this myself in the near future and will report back if I learn anything in the process.

Why might you want to move investment assets?

  1. Consolidate accounts under one brokerage to make things simpler and easier to manage.
  2. Move assets to platforms with more advanced features like M1 with their fancy auto rebalancing using investing allocation “pies”.
  3. Move assets to other platforms where you can borrow cheaply against your investment assets on margin to give yourself a low interest loan. M1 finance and interactive brokers both offer cheap margin loans.

Ease Of Automatic Investing

As I’ve previous written, one way I avoid investment mistakes is to automate my investing as much as possible. Mutual funds makes this very simple as you can setup an automatic schedule to invest like clockwork into your accounts. Example below from my Vanguard account that executes monthly.

ETF’s only trade during market hours and some platforms won’t let you setup to do automatic investing using ETFs. Vanguard and Fidelity won’t let you right now. M1 will I’m told. So, it’s hit or miss.

Here’s an example of me trying to buy an ETF on Vanguard on a Sunday afternoon. Denied!

Investment Fees:

In general, the fees on ETFs are all lower than their mutual fund equivalients. Here’s are a could of examples of a total stock market fund (red) and total bond fund (blue). The mutual funds VTSAX and VBTLX on the left and the ETFs VTI and BND on the right. You can see that they’re just a little bit cheaper.

That said, it’s a really a trivial amount of money in this case so for these funds I wouldn’t use that to drive my decision making. A 0.1% or 0.2% difference would make me think twice though.

Mutual Funds vs. ETFs – Picking The Best Option For You

I’ve given you a lot to consider in describing the features and limitations of each investment type. Lets summarize some of the advantages of each:

ETF Advantages

  • More portable – can be transferred in kind to almost any brokerage without liquidation.
  • No complicated fee structures. Just the expense ratio which is typically lower than the mutual fund equivalent.
  • More tax efficient – few taxable events passed to you.
  • More liquid – trades like a stock.
  • Lower investment minimums.

Mutual Fund Advantages

  • You can automate investing at the big 3 brokerages.
  • Fund availability – there are many more mutual fund options than ETFs. Fidelity, for example, offers 10,000 mutual funds but only 2,700 ETFs. You might not find what you want in ETF form or you might not have any ETF options in your retirement account.

Which Is Right For You?

That’s up for you to decide! One thing to keep in mind is to make sure you get the big things right. Avoiding investing mistakes, maximizing time in the market, low fees and simplicity are factors that I consider quite important.

What Do I Use?

I currently use all mutual funds in my Vanguard brokerage account.

Why? The automatic investing option is really what’s driving that decision above all. I love automation to reduce my work and to remove my brain from tactical decision making.

I trust Vanguard as an institution and love their low fee products. If there was an automatic way to invest ETFs I would go that route all the way. I hope that’s an enhancement that they add soon.

The whole Vanguard target date tax bomb fiasco in 2022 has made me think twice about sticking with mutual funds. I am debating flipping the account to ETFs but haven’t pulled the trigger yet. Partially because I think that a future tax bomb risk is low. This is really bad PR for Vanguard so I’ll be shocked if they don’t make a systemic change to prevent a repeat of this situation.

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iBonds: Good Inflation Protection Or Overrated?

BLUF: iBonds do provide a safe bond that provides inflation protected income. However, with their buying limitations and short term illiquidity you do need to understand their limitations.

It’s always interesting to me when something in the world changes and all of sudden you start hearing about something “new” for the first time. In 2021 and 2022 that something in the world changing was the jump in US inflation rates for the first time in decades.

US Inflation rate by year
Source: https://tradingeconomics.com/united-states/inflation-cpi

The hot “new” investing option that emerged in the news in November of 2021 was this thing called an iBond. They’ve been around since 1998 but since inflation has been fairly low they weren’t all that attractive of an investment option. You can see this peaking of interest in the google search trends.

Google Trends for the term “iBonds”: Source: https://trends.google.com/trends/explore?date=today%205-y&geo=US&q=iBonds

Bonds decrease in value when interest rates go up and raising interest rates is a normal response to inflation. As such, people became worried about their bonds dropping in value with the threat of inflation.

What are these bonds that has everyone so interested? How do they work? When might iBonds make sense for you? I’m going to tackle all of these questions and more along the way.

What is an iBond?

This is a bond invented by Apple. Okay, not really. But if Apple did invent a bond it probably would have been called that.

This is a bond issued by the US government that not only pays a fixed rated of interest, but it also pays an inflation adjusted interest rate. There are many unique things about this bond though that make it quite different than individual bonds or bond funds that you might be used to buying.

We’ll dive into the details of each area of iBonds but here is the high level summary of them.

How Much In iBonds Can I Buy?

iBonds are unusual in that there’s a limit to how much of them you can buy. They’re sold as electronic bonds with a $10,000 per social security number (SSN), per year limit. That means that you’re fairly limited on buying them.

You can buy them on behalf of your spouse or children to increase the amount you can buy. For example, if you were married with 2 kids then you could buy $40,000 / year. An adult needs to open the kids account and then link the kids account to the adult.

Electronic iBonds are sold in any denomination down to the penny from $25 up to $10,000. You could be a $73.96 iBond if you really wanted to. Paper iBonds are only sold in denominations of $50, $100, $200, $500 and $1,000.

How Is iBond Interest Earned?

Things get a little tricky when it comes to calculating the actual interest that you earn on your iBonds. Lets step through the details slowly.

There are two interest rates that make up an iBond.

Fixed Rate: The fixed rate is an annualized rate of interest on your iBond. It’s set when the iBond is issued and never changes over the life of the bond (up to 30 years if you don’t sell it).

Inflation Rate: The inflation rate is the 6 month (semiannual) rate of interest earned on that bond. This is updated every 6 months and usually changes.

Your bond returns are a combination of the annual fixed rate + semiannual inflation rate.

All of these rates can be found here at the TreasuryDirect site.

That interest rate chart is a little confusing without some explanation. Refer to the picture below where I’ve marked up part of the TreasuryDirect interest rate chart to explain what’s going on.

Source: https://www.treasurydirect.gov/indiv/research/indepth/ibonds/IBondRateChart.pdf
  1. Issue Date: Your iBond will fall into one of these 6 month windows depending on the purchase date. These windows run November 1st to April 30th and May 1st to October 31st.
  2. Fixed Rate: The fixed rate is an annualized rate of interest on your iBond. This is set for the life of the iBond.
  3. Semiannual Inflation rate: The inflation rate is a 6 month (semiannual) rate of interest on your iBond. It is updated every May and November using the CPI-U (Consumer Price Index-Urban) metric.
  4. Nov-2020 Column: Annualized rate of return for an iBond based on that 6 month inflation period beginning November 1st, 2020. The inflation rate is the same for the period but then it’s combined with the fixed rate of each row to get the cell cotents.

For the blue box, the 2.18% is the annualized rate for an iBond issued between 5/2019 and 10/2020. Annualized inflation rate (0.84% * 2) + fixed rate (0.50%) = 2.18%.

This is confusing, though, because that inflation rate changes every 6 months. Lets show how this interest is calculated in a real world example.

iBond Interest Calculation Example

Say you bought a $10,000 iBond on March 1st, 2020 which has a fixed rate of 0.2% annualized. You can see the interest rates for that iBond row highlighted in red below.

Over the next 6 months you would get a combined 1.11% interest rate (0.1% fixed + 1.01% inflation). That would pay you $111 in interest which then gets added to the principle starting on 9/1/2020. That’s because the compounding period for an iBond is 6 months.

Inflation dropped to 0.53% for the 6 month block starting on 9/1/2020 so the interest rate for that 6 month block dropped to 0.63%. Using a new principle amount of $10,111, that provides $63.70 in interest over that 6 month block.

This continues on until the iBond matures at 30 years or you sell it. There are no tax consequences while you hold the bond as none of that interest is being distributed to you.

Negative Interest Rates

What happens if inflation goes negative (deflation)? The composite interest rate (fixed + inflation) can never below zero where you’d be giving back interest each month to the government.

However, it is possible the inflation rate to go negative and nullify interest from the iBond’s fixed rate. For example, say you bought an iBond in January of 2019 with a 0.50% fixed rate. If the inflation rate when negative in November of 2022 at a rate of -0.6% then the bond would pay 0% interest for that 6 month period.

This happened in May 2009 when semiannual inflation went to -2.78%. It wiped out the fixed rate returns for even iBonds with the highest fixed rates.

How are iBonds Taxed?

iBonds are subject to ordinary income taxes at the federal level but not to state or local taxes.

It’s important to note that no taxes are due until the iBond is sold or reaches maturity. There are no income taxes to report on an annual basis unless you sold the iBond that year.

How Do I Buy iBonds?

TreasuryDirect.gov login

You can only buy iBonds in two ways.

  • Electronic iBonds – TreasuryDirect.gov sells them online. You are limited to $10k / SSN as previously mentioned.
  • Paper iBonds – If you have a federal tax refund coming to you, you can file IRS form 8888 with your return and direct up to $5,000 in $50 increments to be bought in iBonds.

How Do I Sell iBonds?

Here’s another unique aspect of iBonds, their liquidity (or lack thereof). iBonds aren’t held in a brokerage or retirement account. There is no open market to buy or sell them with other market participants. It’s just you buying and selling them with the US Treasury department.

Just like buying the bonds, you do the selling of them through the treasury direct website.

Can’t Sell iBonds Within A Year

Unless you’re affected by a natural disaster you cannot sell your iBonds within the first year. Here is an iBond that I bought last month. See any sell button? Nope!

Interest Penalty If Sold Within 5 Years

If you sell an iBond within the first 5 years of holding it then you forfeit the previous 3 months worth of interest that you accrued.

How Useful Are These In Your Portfolio?

Time to get to the meat the of what you care about. Are these right for my portfolio?

As we’ve previously covered, iBonds aren’t bought or sold like your other investments. You can’t buy them with a 401k, IRA or brokerage account. You need to create a special account. You can’t buy as many of them as you want due to the $10k/SSN/year limitation. Honestly, they’re kind of a hassle.

If you have a $1M 80/20 portfolio and you wanted to move your bonds to iBonds because of inflation concerns you would need to move $200,000 to iBonds. If you were married it would take you 10 years to make that happen! Not very practical.

You could of course do it slowly over many years where you invest $10-$20k/yr layered in over many years. If we were to have a similar situation as we did in the 1970’s where inflation was up for a decade then this could work out in your favor. You can always liquidate the bonds at any time after that first year. You may have some increased taxes to pay on the gains but that’s a better problem to have than a loss of purchasing power.

Source: https://www.macrotrends.net/countries/USA/united-states/inflation-rate-cpi

Should iBonds Be In Your Emergency Fund?

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What’s the purpose of your emergency fund? It’s to provide cash to save your butt in the event of an emergency. iBonds are illiquid for the first year so you better not buy them using any money that you need to access for with a year. Store that money in a high yield savings account or you could consider a combination of options.

Therefore they aren’t appropriate for most 3-6 month emergency funds. If you had a 2-3 year cash bucket in retirement it would be more reasonable to buy iBonds. But it’s only going to work for a small percentage of that cash bucket to start and could take many years to get the full amount invested.

You’d have to work through your plan and see you wanted to use a combination of HYSA and iBonds to balance returns with liquidity. Just remember though, the purpose of holding cash is usually liquidity, safety and optionality. Not returns.

Holding iBonds In Your “Cash” Retirement Bucket?

The most logical time to consider iBonds would be if you’re going to be holding a fair amount of cash but don’t need to deploy that cash quickly.

If you had a 2-3 year cash bucket in retirement it would be more reasonable to buy iBonds for a portion of that money. But it’s only going to work for a small percentage of that cash bucket to start and could take many years to buy those iBonds depending on that bucket size.

You’d have to work through your plan and see you wanted to use a combination of HYSA and iBonds to balance returns with liquidity. Just remember though, the purpose of holding cash is usually liquidity, safety and optionality. Not returns.

Are iBonds Good Inflation Protection?

iBonds are actually excellent inflation protection for the cash that you are able to invest in them due to their purchasing limits. Inflation rising can often mean the risk of interest rates increasing which hurts bond returns.

iBonds have the unique characteristic of being a stable US backed bond, yet they don’t go down in value if interest rates go up (interest rate risk). Their fixed interest rates are low so the bulk of the return component is that inflation adjusted rate. In a rising interest rate environment of current 2022 (to battle inflation) iBonds get a stronger return from that increasing inflation.

As inflation decreases so do your iBond returns. However, they can never go negative on their interest rate so there’s a backstop on the downside.

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How To Avoid Investing Mistakes When The Market Is Crazy

BLUF: When investors let emotions drive their decisions, they often lose money. Use these tips to help you stick to your plan and avoid making “in the moment” investing mistakes.

Market movement of all kinds can cause a wide range of emotions in us. Those emotions can very easily translate into investor behaviors that can cause long term damage to their portfolios. Selling investments to cash, borrowing to recoup losses and making huge changes to asset allocations are just a few examples of bad behaviors.

We’re going to explore how investing creates emotions and how that can influence bad decisions. We’ll discuss ways that you can minimize those emotions and prevent them from causing actual investing mistakes.

Investing Emotions

Investing is really hard. It would be much easier if we were unemotional robots that only used data and logic to make sound decisions. But being human and not robots, we’re complex, easily triggered balls of emotion that can go from zero to irrational very quickly at times.

With our hard earned money accumulated over many years or decades on the line, investing drives a lot of emotions. We often focus on the negative emotions that occur when markets are drop. However, there are emotions that can be triggered in a variety of market conditions that are both good, neutral or bad.

Investing Emotions

These emotions can create little talk tracks in our brain to get us all sorts of spun up.

Market Up: I’m so good at this investing thing. I’m going to be rich. I’m going to retire early at this rate.

Market Sideways: This is such a waste, my money is going nowhere. How do people make money investing?

Market Down: Why am I investing when it keeps losing me money? I should move to cash to stop losing money. I’m never going to be able to retire.

Not only does market movement create powerful emotions, but losing money in the market generates a pain response in our body. Studies show that investors feel the pain of losing money twice as powerfully as the joy of the equivalent gain. In other words, if you lose $10,000 the pain you feel is twice the level of joy you feel from winning $10,000.

Experienced investors will often use the line that “stocks are on sale” when markets drop and inexperienced investors ask if they should sell. While in theory stocks are cheaper, it’s really a bad comparison to buying an item on sale at a store. There’s no financial pain of loss felt by a consumer that’s considering buying a new TV that’s dropped in price.

Logic Or Emotions: Which One Controls Our Decisions?

But I’m a logical person! This concern about emotions getting in the way of investing decisions clearly is for more emotional people and not me. Right? Wrong. There’s more to decision making than just unemotional logic and reason.

In the book Switch by the Health Brothers they discuss two different decision making forces inside of us as complicated human beings: the thinking brain and the feeling brain.

The thinking brain is the logical, rational part of our brains. It’s the part running calculations and spreadsheet to determine how much house we can afford based on our budget, down payment, interest rate…etc. It’s the part of the brain at the grocery store buying the cheaper tuna fish based on unit price.

The feeling brain is emotional and is making decisions based on how we feel about the decision. It’s the part that walks into an open house for a home that you can’t afford and makes you say: “screw the budget, this feels like home.” It’s the part that sees that shiny black corvette on the car lot and now all you can think about is how awesome it will feel to drive that each day.

A wonderful metaphor for the power scale of these two decision making forces is an elephant with a human rider on top. The feeling brain is actually the massive, powerful elephant while the thinking brain is the puny rider on top.

man riding on gray elephant near trees
Photo by ফাহিম মুনতাসির on Pexels.com

That thinking brain rider may believe that they’re in control because the elephant often listens to their commands. However, when the elephant doesn’t agree with the command the rider quickly learns who’s in control and they’re just along for the ride. The feeling brain elephant is in control and if there’s a conflict between the two it’s going to win. Every. Single. Time.

We often falsely associate being a logical person with making our decisions using logic all the time. The truth is that our emotions and feeling brain hold the power and are the driving force in most of our decision making.

How You Can Avoid Investing Mistakes

Now that we understand that our logical brain is smart but along for the ride, and our emotional brain is unpredictable and in control, the way to avoid investing mistakes should become clear. We need to make our investing decisions when in a logical, unemotional state and then avoid any substantial decisions when emotions are involved.

Stop Watching The Markets

Stop watching the markets

Ever heard the phrase “out of sight, out of mind”? If you don’t see something in front of you, you are less likely to think about it. This rings true when it comes to the stock market.

Stocks are volatile by nature. If you have the habit of looking at the market performance daily, or even many times a day, you’re going to see that volatility.

The financial media knows this and loves to feed off of our emotions. Ever watch Jim Cramer?

Jim Cramer GIFs | Tenor

People like him and the main stream medio love to sensationalize when markets drop. They’re pretty quiet though when markets slowly march upward over time.

A big up event for a market or asset that you don’t own could give you FOMO and an impulse to buy something that you otherwise wouldn’t. A big up day for an asset that you do own could make you pile in more.

A drop for a market or asset that you own could drive the pain of loss making you consider more radical actions like selling all of a particular asset to cash. At a minimum it’s likely to create some level of stress and anxiety that wouldn’t be there if you weren’t aware that it was happening.

In full disclosure, I’ve gotten into the bad habit over the years of watching the markets daily. Pulling open my phone multiple times a day to see what the markets are doing somehow became a habit along the way. Probably from my days trading futures and FOREX where the market trades 24 hours a day from Sunday night to Friday evening EST.

I watch the US market that I own, but also have highly volatile individual stocks on my watch list that I don’t own or have any plan to own. I watch bitcoin, gold and oil whether I plan to invest in them or not.

It doesn’t drive me to change my asset allocation drastically but a big drop on occasion will have me pull from a sinking fund to buy more of something in my plan.

I don’t think of myself as very emotional but I can still feel something inside me as an initial reaction to a big market move. It’s not healthy and I need to break this habit.

So, I’m going to break the habit. I haven’t look at the markets for the few days now and it’s been really hard to resist the urge. But, that will get easier with time. Not looking at them has made it easier to avoid any tactical urges because I just don’t know what’s going on. I’ll have to come up with a healthier cadence but for now let’s go cold turkey for a while.

Have An Investing Plan

Have an investing plan

An investing plan maps out a strategy to get from where you are today to and endpoint that achieves a short or long term financial goal. It gives you some guidelines to work within so that you can resist the urge to do spontaneous things.

Here’s an example from my investing plan (there’s more to it). In the future I’ll go into more detail on how I arrived at all the details here. For this post, the key is that I have a macro asset allocation of 75%/25%. The 75% are all my higher risk assets – stocks, alternatives (real estate) and crypto. The 25% are my low risk assets mostly being bonds and cash.

I break this down into a more detailed asset allocation of US stocks, international stocks, alternatives and bonds/cash. In my case I then translated that into actual investments that I wanted to hold in my portfolio.

This isn’t the complete list because our 401k’s don’t quite have the same options but this gives you a general idea.

With percentages defined for each, and actual investments already chosen, you know how new money should be invested based on your plan.

Having an investing plan gives you a guide. It helps you stay the course and not make drastic changes that don’t align with the plan.

Automate Your Decision Making

A highly effective way to avoid emotional decision making is to avoid decision making altogether! If we setup automatic investing systems based on our plan we take ourselves right out of the regular decision making loop where we often mess things up.

Fortunate for investors, it’s very easy to setup automatic investments. Here’s an example of automatic investments setup for my 401k.

Vanguard, whose main issue is their antiquated user interfaces and systems has automatic investing although it’s only available for their mutual funds at the moment (not ETFs). Here’s an example from one of our accounts.

Some brokers offer automatic rebalancing to a target asset allocation. Or, at a minimum, notification that your asset allocation is X% off from the target so that you can go in and fix it.

Avoid Big Changes To Your Plan

Avoid big changes to your plan

Have you ever been in a car where someone treats the gas and brake pedals like an on/off switch? It’s terrifying. Racing to the next light then braking hard.

It’s also terrifying in investing when you treat your investing decisions as all or nothing like that on/off switch of a cars gas pedal. My stocks are killing it so I should sell all my bonds and go 100% stocks. Oh no, stocks are “high”, inflation is here and the market is correcting. I better sell all my stocks and go to 100% cash.

In the near term, none of us knows what the market is going to do. However, when people talk about making extreme changes to their plan it’s because they all of a sudden “know” what’s going to happen. Stocks are expensive, a big crash is coming. Interest rates are going to skyrocket in the future so bonds are going to get crushed and cash is trash.

This is often fueled by someone in financial media that speaks confidently about knowing the future. They don’t know for sure. The smart ones are making educated guesses. The not so smart ones are making wild predictions and often trying to sell you something off of the fear that they create.

That’s why you come up with an investing plan that’s broadly diversified. If you make adjustments to the larger plan it should be in response to your investing timeline changing, your situation or your risk tolerance. Not external stimuli like geopolitical events, inflation or the movement of the market.

If you do want to make a change, it should be something that’s well thought out over a period of time and a small percentage change compared with your overall portfolio. Make sure that you understand the reasons for the change and that they’re driven by your situation, not external events.

72 Hour Rule For Investing

72 Hour Rule Of Investing

The Frugalwoods have a great concept called the 72 hour rule to help you control your impulsive purchases. The concept is simple: if you want to make a non-essential purchase, you have to give yourself a 72 hour “cooling off period” to think about the purchase and make sure that you really need it.

I think this same concept can be applied to long term investing decisions. If you’re in this for the long term then there’s no change that’s must be implemented TODAY. I’m talking about changes to your plan, asset allocation or individual investment selections. Not normal investment actions that are inline with your current plan.

Instead, after you come up with a change to your investing plan or a tactical move that you want to make, sit on that change for at least 72 hours. That gives you time to ensure that emotions are not influencing your decisions and allows you to reflect on the new plan. If after that period you think the change makes sense, then go for it.

Your investing life will go on just fine if you think through any investing decision for at least 72 hours before going ahead and implementing it. You come up with an idea on Saturday and then think about it until at least Tuesday. The bigger the change, the more time that should be devoted to thinking through the decision.

Key Takeaways

  • Investing generates a wide range of emotions that will encourage you to take action.
  • Your emotional brain is more powerful than your logical brain opening the door for irrational decision making during times of high emotion.
  • Removing or reducing emotions from the decision making process can help you avoid investing mistakes. Not watching the markets, having a plan, automating the plan and having a cooling off period are all ways to avoid mistakes.

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Categories
Expenses Investing

Investing An HSA: Our Retirement Healthcare Fund

BLUF: Retirement healthcare expenses add up over your lifetime. Saving and investing all HSA funds before retirement gives you a large pot of money to cover many of those retirement healthcare expenses.

I’ve written previously about how powerful Health Savings Accounts (HSA) can be as a quadruple tax advantaged account. Given that you can save into an HSA with pre-tax money and then spend that money tax free on medical expenses, why wouldn’t you spend that HSA money today?

I’m looking to play the LONG game. Medical expenses as we age are one of the largest expected spending categories. In this article I’m going to help you understand some average costs for healthcare in retirement and some ways to use the HSA to cover those future costs. I’ll show you our plan to save in our HSA’s, invest and NOT spend them until retirement to cover those healthcare expenses.

Healthcare Costs In Retirement

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Photo by EVG Kowalievska on Pexels.com

Note: all data in this section is from this HealthView Services report.

In the US paying for healthcare is one of the biggest threats to wealth building during our accumulation phase and preservation in retirement.

It’s a cost that’s hard to anticipate and plan for when you’re young. You’re likely in good health and expensive situations are infrequent. You don’t need a large line item in your budget to cover those expenses. As a 41 year old I had a number of procedures last year to investigate a GI issue and it cost me $3,150 out of pocket on our HDHP.

When it comes to premiums, they’re probably fairly affordable when covered by an employer sponsored plan. I’m fortunate that it only costs me about $100/mo for medical, vision and dental premiums and my company subsidizes the rest.

As you can see below, it can be rude awakening when transitioning from an employer sponsored plan to Medicare where you are 100% responsible for the premiums.

Average Healthcare Premium Cost Comparison of 64-Year-Old Couple (Pre-Retirement)
to 65-Year-Old Couple (In-Retirement)
**Medicare Parts B and D, and supplemental insurance Plan G.
Source – Table B

For a healthy 65 year old couple retiring in 2020, they’re projected to live until 87 (male) and 89 (female) and spend $387,644 in healthcare costs over their lifetimes NOT including long term care costs. Those costs include:

  • Premiums for Medicare Parts B and D, supplemental insurance (Mediagap), and dental insurance
  • Out-of-pocket costsrelated to hospitalization, doctor visits, tests, prescriptions drugs, hearing services, hearing aids, vision, and dental.

In 2020 dollars, this means that 65 year old couple would spend the following per year on healthcare.

Future Annual Healthcare costs per year for a healthy 65 retired couple.
Source: http://testing.hvsfinancial.com/hvsfinancial/wp-content/uploads/2020/03/Health-in-Retirement-Planning.pdf

This is all driven by 4.41% healthcare inflation costs per year in addition to you just needing more care as you age.

In a sick twist, the healthier you are, the more money you’ll need for healthcare in retirement. Why? Look at an example between a healthy 55 year old woman and one with type 2 diabetes. The diabetic pays more per year but because her life expectancy is 9 years shorter her lifetime healthcare costs are $266k compared with $424k. Yikes!

Source – table C: http://testing.hvsfinancial.com/hvsfinancial/wp-content/uploads/2020/03/Health-in-Retirement-Planning.pdf

Building That HSA Money Machine For Retirement

person holding green card while using silver laptop
Photo by Kindel Media on Pexels.com

Now that I’ve sufficiently scared you (sorry) with this future costs to plan for, it’s time to discuss some ways that an HSA can be used to cover these future expenses

Spend HSA Money On Current Medical Expenses

This is the most common way that an HSA is used. Similar to how people use a flexible spending account that doesn’t carry over year to year, many people use an HSA to pay for medical expenses on demand. Money goes in pre-tax and you can use it to pay your medical expenses tax free.

There’s nothing wrong with this approach. You get the tax savings of funding with pretax money and paying the expenses tax free. However, you’re effectively using the HSA like a checking account. Your money isn’t making you any additional money to pay for future expenses.

Let’s create an example where you have a 40 year old couple that just started their HSA’s with $0. They contribute the max $7,300 to their HSA’s for every year until they turn 65. However, they spend half of it ($3,650) each year on current medical expenses. The other $3,650 is invested getting a 5% real return (nominal – inflation) for 25 years. This is a bit conservative as historically this is 10% nominal returns and 3% inflation.

Over those 25 years you would have contributed $91,251 and it would have grown to $181,775 in todays dollars (net present value).

Certainly a nice chunk of change. That would cover more than half the average retirees medical expenses.

Pay Out Of Pocket For Medical Expenses, Invest the HSA

There is another way though. You could max that HSA and pay all your out of pocket medical expenses with after tax dollars instead of using the HSA money.

Why do that? Two reasons really:

  1. You’re giving more time for that sweet tax free forever money to compound.
  2. By paying your current medical expenses with after tax money you’re paying taxes today instead of making your future retired self pay income taxes to cover medical expenses (when your HSA runs out). Very similar to investing in a Roth / Roth 401k where you pay the taxes today and your future self doesn’t have to.

I think of it as taking one less risk out of retirement by letting that HSA grow as large as possible. After all, if you don’t need it you can always spend it on non-medical expenses and be taxed as ordinary income.

Let’s run the same scenario for that 40 year old couple except this time they’re going to save and invest the full $7,300/yr for 25 years.

With 5% real return you end up with a net present value of your HSA after inflation of…double! You contributed twice as much at $182,502 and that money doubled to $363,550. That’s pretty close to the $387,000 to the projected retirement healthcare expenses!

How sweet would it be to not have to worry about your main portfolio covering your healthcare?

Our HSA Investing Plan

white paper with note
Photo by Bich Tran on Pexels.com

One reason that I love thinking through and writing about financial topics is that it makes me take a hard look at my own actions and see if I need to make a change in our own plan. This article is one of those cases.

Our Old Plan

For the last few years we’ve been paying out of pocket for all medical expenses and investing those HSA funds to let the money compound. I knew we would use that HSA money in the future, but I hadn’t thought through our planned time horizon and how we might use the money.

I had been investing our HSA’s inline with the asset allocation of our overall portfolio – roughly 75% stocks, 25% bonds/cash. VTI for a total US market index and TLT for long term treasury bonds. The bonds being for stability and in case we needed the funds. You can see that below in my HSA account. Mrs. MFI’s HSA investment account is invested similarly.

Our New Plan

Our new plan gets more specific on the planned time horizon to use the money and how we might use the money. And, because we have a plan for the money, an adjustment in the asset allocation.

Time Horizon: Use our HSA money starting at age 65.

Money Use: You can use HSA money for Medicare part B,C & D premiums so we’d use the money then. Normal medical expenses as well.

Asset Allocation Changes:

If you have 24 years (age 41 to 65) with no planned need to touch the money then there’s no reason for us to be in bonds right now. We have enough in cash to cover our HSA deductibles. As such, I’m going to move these buckets of money to a 100% stock allocation.

While the US market is great, and has been on a tear for many years, I think it’s prudent to mix in international stock exposure. I compared a VTI/VXUS (VGTSX is similar) mix to 100% VT (simpler) in portfolio visualizer to see how they compared. VT is 60% US, 40% international stocks so this is the true apples to apples comparison. The VTI/VXUS (VGTSX) outperformed by almost a percent per year compounding annual growth rate (CAGR) for the last 14 years (2008 – 2022).

Since I want to allocate a little heavier towards the US I’m going to go with 75% US / 25% international stock index funds . The past performance difference grows wider of course give the US markets performance although that doesn’t guarantee the future. It’s entirely possible that international markets perform better over the next 20 years but I’m not one to bet against the US.

So that’s what I went with and I executed that change this past week and moved all my bond positions into VXUS giving me a 100% stock allocation in my HSA. I’ll be changing over Mrs. MFI this week. VXUS is a low expense ratio (0.08%) international fund that invests in non-US equities.

This puts me right at a 75% allocation is the US total stock market with VTI and a 25% allocation in the non-US international stocks markets with VXUS.

HSA Growth Projections

We currently have $30,000 in HSAs at age 41. We plan to keep maxing out those HSAs at $7,300 total per year for the next 10 years. At a 5% real return (actual return – inflation) that would give us $144,000 in todays dollars.

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If we then kept that money invested for another 14 years, from age 51 to 65, with no contributions that money would grow at 5% real returns to $290,000.

At that point we would have glided to a more conservative 60/40 stock/bond portfolio. $290,000 in today’s dollars covers a good portion of the $387,000 in healthcare costs expected for a couple over their lifetime but there clearly is a shortfall.

It’s hard to find a calculator that lets you increase the withdrawals but this one let me add a % increase to my withdrawals through the use of the inflation adjustment. Since I’m using real returns inflation is already accounted for in the returns.

I put 6% for the expenses to increase each year which aligns pretty good with a 65 year old couple spending $12,000/yr and then that increasing to $21,000 by 75 and $34,000 by 85 (estimation provided earlier).

With a 5% real return we’d run out of HSA money at 87 years old.

Note: Withdrawal setup to start at $12,000/yr and increase at 6%/yr.
Calculator: https://www.tcunet.com/Plan/Calculators/Planning-Calculators/Investment-Savings-Distributions-Calculator

A small shortfall if we live that long that would need to be paid out from other money. Although, given how many assumptions go into these projections, this potential shortfall is something to worry about when we get closer to 65.

One elephant in the room that I haven’t mentioned are long term care costs. Those are non-medical costs related to help you perform everyday life tasks that you can’t do on your own. That’s a risk in retirement that can be handled in many ways so we’ll cover that topic on it’s own at another time.

One other thing is that there are FAR cheaper options for quality healthcare outside of the US. If you’re concerned about these costs and not tied to living in the US then that could be an option for you.

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What’s your HSA plan? Do you spend it or invest it? How does that fit into your retirement healthcare plan? Comment below, I’d love to hear from you.

Categories
Taxes

The Retirement Tax Triangle: Give Yourself Options

BLUF: It’s impossible to predict how future tax laws will change. By saving in all retirement tax triangle accounts with diverse tax treatment we give ourselves more options to control our taxation in retirement.

When you get into the details of saving for retirement, one thing you figure out is that not knowing the future makes planning really hard. One planning area where this is especially difficult is the area of taxation. One this is for certain though, you’re going to have to deal with taxes in retirement.

Income taxes, capital gains taxes, federal, state, foreign…big brother wants a piece of your money. If you’re…human, then you despise taxes and want to do what you can to minimize those taxes and keep that money.

In this article we’re going to talk about the different ways that you can diversify your investment holdings from a taxation perspective. We’ll walk though examples of how those different tax treatment buckets gives you options to minimize your taxes in creative ways.

The Tax Triangle – Helping To Plan For Future Tax Uncertainty

white moon on hands
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Why is this topic important in retirement planning? As previously mentioned, paying taxes are one certainty that isn’t going to change. Taxes add on to your future liabilities so you need to account for them in your FI number.

In retirement and early retirement it’s likely that your effective tax rate will fall as most of us will have less income, but it won’t be zero. The 4% rule of thumb doesn’t account for taxes so you need to plan for that as a separate expense.

Oh, and the government changes the tax laws A LOT. Here’s just a sample of the major legislation impacting taxes that has passed over the last 25 years. Well within a normal retirement period. I don’t envy the CPA’s that have to keep up with all of this!

As you can see, it’s a near certainty that US tax laws are going to change over the course of any persons retirement. The laws tend to change in some way every 3-5 years.

As you’ll learn, putting money in all three tax buckets give us some amount of control of our tax rate. We don’t make the tax laws but the amount of income that we can draw from each tax bucket allows us to manipulate our effective tax rate in any given year.

Retirement Income Sources

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Photo by Pixabay on Pexels.com

Many people are working for others as either a 1099 contractor or W-2 employee to make a living. Other than contributing to tax advantaged retirement accounts you don’t have much control over how you’re taxed.

In retirement, however, you have the ability to draw from a number of potential income sources which get different tax treatment.

  • Guaranteed Income – Pensions, social security (ordinary income taxes), annuities (taxation varies)
  • Business Income – Real estate income, other business income (taxation varies)
  • Taxable Investment Accounts – Brokerage accounts (capital gains taxes)
  • Tax Deferred Investment Accounts – Traditional IRA accounts (ordinary income taxes)
  • Tax Free Investment Accounts – Roth IRA, Health Savings Account (HSA) spent on qualified expenses (tax free)

Guaranteed income is great, but your options are limited on controlling taxation of that money. Business income is very situation specific and is outside the scope of this article. We’re going to focus on the last three investment account options for giving us tax options in retirement since those are more broadly available.

The Retirement Tax Triangle

The tax triangle is a way to describe three different categories of investment accounts that each receive different tax treatment. These categories are: tax free, taxable and tax deferred.

Tax Free Accounts

No taxes are due on the sale of investments or withdrawal of money in tax free accounts as long as the correct rules are followed.

Roth versions of retirement accounts are the most common. You can buy, sell and withdraw contributions at any time. After age requirements are met you can withdraw investment gains tax free. You contribute to them with after tax money.

I wish my parents had started a Roth account for me as a teen, or had at least knew about the Roth early in my 20’s. At $6k/yr it requires a lot of time to build up a lot in that bucket unless you have access to the mega backdoor Roth.

HSA’s, covered extensively here, can be invested. Buying and selling of investments in those accounts is not taxable. When you withdraw money from the account for qualified medical expenses the money is tax free even though you got to contribute to the account with pre-tax dollars!

Cash! There’s no tax on the withdrawal of cash held in bank accounts or taxable investment accounts.

Taxable Investment Accounts

These investment accounts are your standard brokerage accounts at Schwab, Fidelity or Vanguard. You move after tax money into these accounts and invest your money as desired. These could also be crypto brokerage accounts.

Any sale within these accounts is a taxable events and income distributions in the form of interest and dividends are subject to tax. However, investments held for a year and a day and sold get the advantage of special long term capital gains (LTCG) treatment. If you don’t hold investments for over a year and sell them they are considered short term capital gains (STCG) and are taxed as ordinary income like your paycheck.

LTCG get taxed at 0%, 15% and 20% LTCG taxation rates in 2022 which is MUCH lower than ordinary income tax rates. For example here’s how the ordinary tax rate has compared to the the LTCG tax rate in recent years.

Notice that 0% tax bracket? That’s a taxation sweet spot that we’ll discuss more. We definitely want to take advantage of that when possible!

*Starting in 2018 the ordinary income tax brackets aren’t tied to the LTCG tax brackets. They’re close for the 0% and 15% brackets, quite a bit different for the top of the 15% bracket

Tax Deferred Investment Accounts

These are some of the most common retirement accounts as they’ve been around the longest. The money is called tax deferred because you get to contribute to the accounts pre-tax, let the money grow without taxation and then the taxation happens when you withdraw the money from the account.

The money withdrawn from the accounts are taxed as ordinary income when withdrawn from the account at your marginal tax bracket. These taxation rates for ordinary income and their taxable income ranges are shown below.

These are most commonly called traditional accounts. Examples of common retirement accounts that are tax deferred are the tradition versions of an IRA, 401k, 403b, 457b and Thrift Savings Plan (TSP).

How Income “Stacks” For Taxation

Before we talk about some of the ways that the tax triangle can be used to minimize taxes in your situation, it’s important to understand the ordering rules for taxing of your income.

Think of taxation order as a cake and the layers are taxed starting at the bottom and working your way up.

Standard Deduction: Your standard deduction is removed from your ordinary income layer first. In 2022 this is $25,900 for joint filers. If for some reason your ordinary income is less than your standard deduction then it’s used to reduce your long term capital gains.

It’s important to remember that when you look at income tax tables, what is shown is the taxable income left AFTER the standard deduction is removed.

For example, if you made $40,000 in ordinary income as a married couple in 2022, your taxable income after the standard deduction is $40,000 – $25,900 = $14,100. Taxed all at the 10% marginal bracket you’d pay $1,410 in tax for the year on that $40,000 income.

Ordinary Income: Everything that is taxed as ordinary income falls into that layer as the bottom layer. All earned income resides here including salaries, interest income, bonuses, short term capital gains and traditional IRA withdrawals. Social security has some unique tax treatment so it isn’t just taxed completely as ordinary income.

Frequently misunderstood: Bonus tax treatment.

Bonuses are taxed as ordinary income. Your employer may withhold extra money from a bonus but it’s not taxed any differently than your salary. In the end, if you paid extra extra tax on a bonus up front then you’ll get it back at tax time.

Long Term Capital Gains: Investments sold in taxable investment accounts and qualified dividends paid (whether reinvested or not) are all income that receives long term capital gains treatment. As you can see below, the tax rates are FAR lower than ordinary income.

Tax Free Income: Income from Roth withdrawals is tax free as is withdrawals from bank accounts or cash inside brokerage accounts.

LTCG Calculation Example

This may seem obvious to some, but it’s critical to understand how to calculate long term gains properly. It is common to confuse the gains of a sale with the overall cash received from a sale. Let’s walk through an example to make sure that it’s clear.

In 2021 you purchased 200 shares of VTSAX in a taxable brokerage account for $100 per share. This is your cost basis for the investment – what you payed for it. In 2025 those shares were worth $150 per share and you sold all 200 shares.

Your brokerage account would show $30,000 in cash from the sale, but you’re only taxed on the capital gains. In this case, you’re taxed on $10,000 of long term capital gains.

Newer investments that haven’t had time to appreciate as much will have less capital gains as a percentage of the sale. Older investments that have had more time to grow will have more capital gains as a percentage of the sale.

Examples Of Tax Triangle Drawdown Flexibility

Now, for the fun part. Showing how having funds in all three buckets of the tax triangle gives you options to control your tax rate. I know, I have a weird idea of fun.

Let’s pretend that for all scenarios a married couple (age 60) needs $60k/yr after taxes to live and are retired. They have no pensions and they won’t take social security until 67. The year is 2021 and those tax brackets will apply. The couple lives in a state that has no state income tax.

Scenario #1: $2M in traditional 401k’s. No money in Roth or taxable accounts. Withdrawing enough to live on, $60k after taxes.

In this case you have limited options. All that money is taxed as ordinary income. You need to pull out $64,310 which will result in you paying $4,310 in federal income taxes. Your effective tax rate is 6.7% ($4,310 / $64,310).

Source: Nerdwallet 2021 Federal Tax Calculator

Scenario #2: $2M in traditional 401k’s. No money in Roth or taxable accounts. Withdrawing enough to live on, $60k after taxes. Also, complete $60k in Roth conversions (net of taxes) to reduce future required minimum distributions (RMDs).

Once again, your options are limited to just withdrawing more money from the 401k accounts pushing you into higher tax brackets to pull enough money to cover the Roth conversions. As a result, you need to pull $135,972 from the 401k paying $15,972 in federal income taxes. Your effective tax rate is 11.7% ($15,972 / $135,972).

Scenario #3: $1M in traditional 401k’s. $500k in Roth and $500k in a taxable account. The couple needs $60k to live and wants to do a $60k Roth conversion. The $60k to live is pulled from the Roth IRA.

In this case, the couple is going to do the $60k Roth conversion from their 401k. That money is all taxable income and they pay $4,310 in taxes just like in scenario #1. Since $60k in Roth money is withdrawn to live on that is tax free. In total $4,310 in tax was paid on $124,310 ($64,310+$60,000). A total effective tax rate of $4,310 / $124,310 = 3.46%.

Source: Nerdwallet 2021 Federal Tax Calculator

Scenario #4: $1M in traditional 401k’s. $500k in Roth and $500k in a taxable account. Taxable account has 5,000 shares of VTSAX at a $50 cost basis, $100 current share price. The couple needs $60k to live and wants to do a $60k Roth conversion. The $60k to live is pulled from the taxable account.

In this case, the couple is going to do the $60k Roth conversion from their 401k. That money is all taxable income and they pay $4,310 in taxes just like in scenario #3.

Source: Nerdwallet 2021 Federal Tax Calculator

To get $60k to live on the couple sells 600 shares of VTSAX at $100/ea resulting in $60k in their account. The capital gains on those are 600 shares * ($100/share – $50/share cost basis) = $30,000.

The taxable income is $39,210 in ordinary income from the Roth conversion + $30,000 in LTCG taxes = $69,210 in taxable income. Since this amount is less than $80,800 it’s in the 0% LTCG bracket and the couple will pay $0 in tax on that $30,000!

This makes the taxable account act like a tax free Roth account as in scenario #3. In total $4,310 in tax was paid on $124,310 ($64,310+$60,000). A total effective tax rate of $4,310 / $124,310 = 3.46%.

There are obviously an infinite number of scenarios that could play out using the combination of these accounts. In other words, lots of options!

What’s The Ideal Tax Triangle Mix?

We all love to have definitive answers to questions like this. Unfortunately, there is no perfect answer. The key is to understand the impact of having money in the account mix that you have and coming up with a plan for how you will empty those accounts in retirement.

I think there’s power in trying to save some percentage in all of these accounts as you saw from the earlier scenarios. It gives you the flexibility to deal more effectively with future tax legislation changes.

Some things to think about:

  • Think about your own retirement plans and how these accounts will fit into them. Begin with the end in mind and see if your current account mix would work with a drawdown plan.
  • If you have a long period planned with no or low income, you can get away with larger tax deferred balances. You can withdraw or Roth convert down those balances before social security or pensions start.
  • Roth contributions today instead of traditional IRA contributions eliminate a tax liability in retirement.
  • Long term capital gains tax rates have historically been much better than ordinary income tax rates.
*Starting in 2018 the ordinary income tax brackets aren’t tied to the LTCG tax brackets. They’re close for the 0% and 15% brackets, quite a bit different for the top of the 15% bracket

What Am I Doing?

If you read my last article about our portfolio composition, you saw this portfolio breakdown below. Traditional 401k accounts dominate our portfolio at the moment at 62.5%. At the moment we’re also saving $50k into tax deferred accounts each year which is also the most that we add to any account. This will accelerate the imbalance although the goal isn’t necessarily to be in balance.

The goal is to make sure that you have some diversity in investment locations and a plan for how to unwind those in a tax optimized way. It’s good to plan but don’t get too fixated on it. Tax planning is based on many variables that are out of control that change frequently. Taxation levels, tax laws and your relationship status (single/divorced/widowed vs. married) all can have major impacts.

In 2026, if no tax legislation changes first, the Tax Cuts and Jobs Act of 2017 will expire and ordinary income tax rates will increase. 12% -> 15%. 22% -> 24%. 24% -> 28%. Mrs. MFI and I both have options to invest in Roth 401k accounts.

Current tax rates are historically low but at our high income they’re still higher than I’m likely to encounter in retirement. Do I want to pay a locked in 24% tax today by switching to a Roth 401k to avoid paying taxes in retirement that are likely lower, but still variable in rate? I don’t know. That’s a tough one that I’m going to have to ponder some more and do some math.

Key Takeaways:

  • Tax legislation is ever changing and impossible to predict.
  • Investing in a mix of tax deferred, taxable and tax free accounts gives you the greatest flexibility in retirement tax planning.
  • Investing in tax deferred accounts today means avoiding taxes at todays ordinary income tax rate in exchange for taxation on this money at future ordinary income tax rates. There will be RMDs. However, keep in mind that you’ll be declaring less income in retirement so your taxes should be far less because you’ll lower tax brackets.
  • Investing in Roth accounts today means being taxed at todays ordinary income tax rate in exchange for no taxation in the future. There are no RMDs.
  • Investing in taxable accounts today means being taxed at todays ordinary income tax rate in exchange for special tax rates in the future. There are no RMDs.

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