Personal Finance Financial Planning & Investing

[BamaNation]

we will be paying off our mortgage next week.

our goal was to have it done by the time i was 50, but the whole covid kerfuffle slowed us down by a few months and i turned 51 over the summer.

aside from the mortgage, we have been debt free for several years and have been aggressively paying off the mortgage principal.

We want pics of the mortgage burning ceremony!

 

[Bamaro]

Is this potentially signaling higher interest rates for CDs?

Treasury Yields Surge Again
Benchmark 10-year note trades up above 1.7%

Selling in U.S. government bonds accelerated on Thursday, sending yields soaring again a day after the Federal Reserve had seemed to calm the market.

In recent trading, the yield on the benchmark 10-year U.S. Treasury note was 1.731%, according to Tradeweb, compared with 1.641% Wednesday.

Yields, which rise when bond prices fall, have been climbing for months, lifted by expectations for a vaccine- and government-stimulus fueled economic recovery that investors think could lead to significantly higher inflation and eventually force the Fed to lift short-term interest rates.

Treasury Yields Surge Again - WSJ

 

[BamaNation]

Is this potentially signaling higher interest rates for CDs?

Treasury Yields Surge Again - WSJ

Here's a good read on the impact of Treasury yields: How U.S. Treasury Yields Affect the Economy (thebalance.com)

I typically look at Ally & Marcus & CIT Bank to see what's happening in "real time" CD rates. They're still at 0.50%. Probably more impactful than a fluctuating "market" rate on Treasurys is the Fed Funds rate which hasn't changed in a year.

There are some 1yr CDs available for up to 0.80% from other smaller / local banks & CU's but those tend to be a lot harder to "manage" than the online banks I use so I'm willing to give up a little return for convenience. At this point I have no CDs because the savings rate at Ally & Marcus is same (or within 0.05%) as the CD rate.

The rising treasury rate also impacts total bond fund prices & returns. So, I tax loss harvested bonds a couple weeks ago and will probably put back into bonds after 30 days (to avoid wash sale rules). I've also looked at Treasurys but I've never bought them directly and the SEC Yield on the total bond funds has been > 2% for me over last year so I would rather get that better 2% return on the high quality bond funds than dealing with Treasurys at this point. But that's just me. Depends on your risk tolerance and purpose to decide what works best.

Here's a chart showing last 3.5 years of 1yr CDs vs Fed Funds rate

 

[4Q Basket Case]

I haven’t considered bonds for some time now.

The difference between short term yield and long term yield just isn’t very much. And the exposure to loss of market value literally goes up faster than a hockey stick as you move out maturities.

So I have my cash allocation in cash. Yields next to nothing. Less than nothing when you figure in inflation (however you might calculate that). But I won’t be in 10+ year bonds that lose a godamighty portion of market value if rates rise by 1.5% - 2%, which given 5+ trillion in stimulus, I expect.

Bottom Line: It’s a great time to be a borrower. Not so much if you’re a lender....which you are if you buy bonds.

 

[UAH]

Speaking of borrowing... Is anyone following the Archegos Capital news story that has led to two major Japanese banks taking $ Billions write offs due to loans made to Archegos Capital, a family office, for margin purchases in the US and Chinese markets. Archegos Capital failed a margin call resulting in the write downs in Japan and the unwinding of multi- billion market positions by Goldman Sachs and Morgan Stanley this week.

Financial Times

This could be the tip of the iceberg with many hedge funds and investment houses setting on $ Billions in margin leverage that will become difficult/impossible to maintain as interest rates rise.

 

[4Q Basket Case]

Speaking of borrowing... Is anyone following the Archegos Capital news story that has led to two major Japanese banks taking $ Billions write offs due to loans made to Archegos Capital, a family office, for margin purchases in the US and Chinese markets. Archegos Capital failed a margin call resulting in the write downs in Japan and the unwinding of multi- billion market positions by Goldman Sachs and Morgan Stanley this week.

Financial Times

This could be the tip of the iceberg with many hedge funds and investment houses setting on $ Billions in margin leverage that will become difficult/impossible to maintain as interest rates rise.

I’m deadly curious as to the details, which haven’t come out yet.

Buying stocks on margin blurs the distinction between investing and gambling. First, you don’t just have to be right that the stock will go up, you have to be exactly right as to the timing of the increase. Second, you’ve borrowed money to buy the stock.

For regular investors, you usually have to put up at least half the purchase price, and the brokerage house puts up no more than the other half. So on Day 1, the broker has no greater than 50% Loan to Value (LTV).

While you hold the position, the value of the underlying stock changes daily. It goes up, it goes down. So long as the broker‘s LTV doesn’t exceed a pre-agreed-upon number, say, 75%, no money changes hands.

But if the value of the stock declines to the point that the LTV is, say, 80%. The broker / lender requires a paydown on the loan (aka “margin call”) to reduce their LTV to a different pre-agreed-upon point. Might be the 75% number, but because a further decline would initiate another margin call immediately, it’s likely something lower. Maybe even down to the original 50% LTV.

If the borrower / stock owner can’t cough up the cash in very short order (like that day), the broker/lender sells the stock to pay off their loan.

Now, all that’s for you and me — if you can get approved to buy on margin.

If you’re a $10B hedge fund, even if it’s a family company, all those points — initial LTV, the point at which you face a margin call, time to make the payment, etc., etc. get a lot more negotiable.

Something to think about — the stock market as a whole has regularly been hitting new highs lately. So if Archegos’ portfolio had been declining to the point that not only did they trip margin calls, the value of the stock no longer covered the loan amount (which has to be the case if the brokerage houses are booking losses), they had to be in some extremely speculative stocks.

I have no idea which specific stocks they had to have, but Tesla, GameStop and similar meme names would fit. I just can’t come up with anything else that would logically go through that kind of decline, that quickly, in an environment wherein equities as a whole are going up.

The article suggests the brokerage houses didn’t know their customer. I promise you, they knew, and knew the history of shady dealings. They just played a game of intellectual Twister, and talked themselves into some sort of rationalization because they wanted the fees and interest that go along with margin loans.

It’s possible they might not have known about how much the Huang family company owed to other houses on what stocks because they didn’t ask. Or it’s possible that they dotted that ’i’, but were given falsified financial statements. Another detail I’d love to know.

The numbers just aren’t big enough to affect the markets as a whole, so I’m not worried about a contagion.

And I disagree entirely with the article’s assertion that rises in interest rates could make the margin loans untenable. That happens only with declines in the value of the underlying stock.

It is possible that rising interest rates could erode stock values. But because rates are rising relatively slowly, and at a pace largely already priced in, we haven’t seen that yet.

This isn’t going away anytime soon, and I’m deadly curious to get details.

 

[UAH]

I’m deadly curious as to the details, which haven’t come out yet.

Buying stocks on margin blurs the distinction between investing and gambling. First, you don’t just have to be right that the stock will go up, you have to be exactly right as to the timing of the increase. Second, you’ve borrowed money to buy the stock.

For regular investors, you usually have to put up at least half the purchase price, and the brokerage house puts up no more than the other half. So on Day 1, the broker has no greater than 50% Loan to Value (LTV).

While you hold the position, the value of the underlying stock changes daily. It goes up, it goes down. So long as the broker‘s LTV doesn’t exceed a pre-agreed-upon number, say, 75%, no money changes hands.

But if the value of the stock declines to the point that the LTV is, say, 80%. The broker / lender requires a paydown on the loan (aka “margin call”) to reduce their LTV to a different pre-agreed-upon point. Might be the 75% number, but because a further decline would initiate another margin call immediately, it’s likely something lower. Maybe even down to the original 50% LTV.

If the borrower / stock owner can’t cough up the cash in very short order (like that day), the broker/lender sells the stock to pay off their loan.

Now, all that’s for you and me — if you can get approved to buy on margin.

If you’re a $10B hedge fund, even if it’s a family company, all those points — initial LTV, the point at which you face a margin call, time to make the payment, etc., etc. get a lot more negotiable.

Something to think about — the stock market as a whole has regularly been hitting new highs lately. So if Archegos’ portfolio had been declining to the point that not only did they trip margin calls, the value of the stock no longer covered the loan amount (which has to be the case if the brokerage houses are booking losses), they had to be in some extremely speculative stocks.

I have no idea which specific stocks they had to have, but Tesla, GameStop and similar meme names would fit. I just can’t come up with anything else that would logically go through that kind of decline, that quickly, in an environment wherein equities as a whole are going up.

The article suggests the brokerage houses didn’t know their customer. I promise you, they knew, and knew the history of shady dealings. They just played a game of intellectual Twister, and talked themselves into some sort of rationalization because they wanted the fees and interest that go along with margin loans.

It’s possible they might not have known about how much the Huang family company owed to other houses on what stocks because they didn’t ask. Or it’s possible that they dotted that ’i’, but were given falsified financial statements. Another detail I’d love to know.

The numbers just aren’t big enough to affect the markets as a whole, so I’m not worried about a contagion.

And I disagree entirely with the article’s assertion that rises in interest rates could make the margin loans untenable. That happens only with declines in the value of the underlying stock.

It is possible that rising interest rates could erode stock values. But because rates are rising relatively slowly, and at a pace largely already priced in, we haven’t seen that yet.

This isn’t going away anytime soon, and I’m deadly curious to get details.

After posting the original FT article stories began to surface that Archegos Capital was trading synthetic derivatives - credit swaps, etc. much like those that led to the 2007-2008 financial catastrophe. Essentially they would be using leverage to trade derivatives that would create multiples of their original debt exposure. Their intent was to move their base investments, long or short, in the direction they desired. In their case any significant market volatility could impact their positions and illicit margin calls.

This is the "moral hazard" the Fed has created with their underpinning of the market since 2000 and the failure of Congress to properly supervise the major banks after they were rescued by the public twice in last twenty years.

If Archegos Capital is trading synthetic derivatives that are not measurable in terms of the multiples of leverage that are at risk in the market then certainly many others are as well. Personally I hope we are not into another Long Term Capital or worse situation!

 

[B1GTide]

After posting the original FT article stories began to surface that Archegos Capital was trading synthetic derivatives - credit swaps, etc. much like those that led to the 2007-2008 financial catastrophe. Essentially they would be using leverage to trade derivatives that would create multiples of their original debt exposure. Their intent was to move their base investments, long or short, in the direction they desired. In their case any significant market volatility could impact their positions and illicit margin calls.

This is the "moral hazard" the Fed has created with their underpinning of the market since 2000 and the failure of Congress to properly supervise the major banks after they were rescued by the public twice in last twenty years.

If Archegos Capital is trading synthetic derivatives that are not measurable in terms of the multiples of leverage that are at risk in the market then certainly many others are as well. Personally I hope we are not into another Long Term Capital or worse situation!

Remember, after the 2008 bailouts we did not reenact any of the laws that prevented this type of gambling with depositor assets. Insurance companies and banks are still free to take our money to Vegas if they wish, and lose everything on a single spin of the wheel.

This is happening because it can happen, legally. After Enron we enacted Sarbanes Oxley, and that was one company. After 2008, we did nothing. Nothing.

 

[PA Tide Fan]

I haven’t considered bonds for some time now.

The difference between short term yield and long term yield just isn’t very much. And the exposure to loss of market value literally goes up faster than a hockey stick as you move out maturities.

So I have my cash allocation in cash. Yields next to nothing. Less than nothing when you figure in inflation (however you might calculate that). But I won’t be in 10+ year bonds that lose a godamighty portion of market value if rates rise by 1.5% - 2%, which given 5+ trillion in stimulus, I expect.

Bottom Line: It’s a great time to be a borrower. Not so much if you’re a lender....which you are if you buy bonds.

Agree that most any bond fund is poor right now. Something worth a look though might be I-Bonds. At least a person keeps up with inflation. Can only purchase $10K electronically and $5K paper per year though. Must hold them at least 1 year and 3 month interest penalty if cashed out in less than 5 years. 30 year final maturity date.

 

[BamaNation]

Bonds aren’t providing much in way of return right now, but yield is around 2%. BND price has stabilized somewhat over last 5 weeks. They’re in our portfolio if only for ballast in a downturn but we have 10 years before retirement so expect them to grow in meantime while we buy low.

Currently, you can either lose to inflation or negative growth on any high quality fixed income avenues or lock in low rate with iBonds and treasuries. CDs and savings get you around 0.5% at the online banks. Not much to like anywhere.

 

[4Q Basket Case]

Bonds aren’t providing much in way of return right now, but yield is around 2%.

You can either lose to inflation or negative growth on any high quality fixed income avenues or lock in low rate with iBonds and treasuries. CDs and savings get you around 0.5% at the online banks. Not much to like anywhere.

Stone cold fact.

I know you know all this, Brett. But I’ll go into some cause-and-effect for those not as understanding of the details.

The thing cash provides right now is preservation of opportunity given what I think is coming.

I think the various stimulus, infrastructure, and other projects that flood the markets with cash will cause inflation. At the multi-trillion dollar level, they can’t not cause inflation.

Inflation causes increases in interest rates. The Fed may control the very short term interest rates, but the market controls everything else, and I think their (the Fed’s) monetary policy will drive inflation and therefore increased longer term interest rates.

Thing is, if you’re in, say, a 10 year bond paying 2%, and prevailing 10 year rates go to 3% (I think they’ll go higher, but that’s just me), you lose a ton of market value. If you hold on until maturity, you‘ll get your money back. But in the meantime, you’re collecting 2%, while the market is collecting whatever the prevailing rate is — and due to inflation, the principal you get back at maturity will have less purchasing power.

So even though I’m 62, and retired, I hold more cash and equivalents today than the “book” would say, anticipating that the historically low rates can’t hold.

I’ll invest in bonds when rates are more attractive. In the meantime, I think the risk of erosion of market value is greater than the risk of little to no (maybe negative) return on my cash for the next 6-12 months.

 

[BamaNation]

I’m deadly curious as to the details, which haven’t come out yet.

Buying stocks on margin blurs the distinction between investing and gambling. First, you don’t just have to be right that the stock will go up, you have to be exactly right as to the timing of the increase. Second, you’ve borrowed money to buy the stock.

For regular investors, you usually have to put up at least half the purchase price, and the brokerage house puts up no more than the other half. So on Day 1, the broker has no greater than 50% Loan to Value (LTV).

While you hold the position, the value of the underlying stock changes daily. It goes up, it goes down. So long as the broker‘s LTV doesn’t exceed a pre-agreed-upon number, say, 75%, no money changes hands.

But if the value of the stock declines to the point that the LTV is, say, 80%. The broker / lender requires a paydown on the loan (aka “margin call”) to reduce their LTV to a different pre-agreed-upon point. Might be the 75% number, but because a further decline would initiate another margin call immediately, it’s likely something lower. Maybe even down to the original 50% LTV.

If the borrower / stock owner can’t cough up the cash in very short order (like that day), the broker/lender sells the stock to pay off their loan.

Now, all that’s for you and me — if you can get approved to buy on margin.

If you’re a $10B hedge fund, even if it’s a family company, all those points — initial LTV, the point at which you face a margin call, time to make the payment, etc., etc. get a lot more negotiable.

Something to think about — the stock market as a whole has regularly been hitting new highs lately. So if Archegos’ portfolio had been declining to the point that not only did they trip margin calls, the value of the stock no longer covered the loan amount (which has to be the case if the brokerage houses are booking losses), they had to be in some extremely speculative stocks.

I have no idea which specific stocks they had to have, but Tesla, GameStop and similar meme names would fit. I just can’t come up with anything else that would logically go through that kind of decline, that quickly, in an environment wherein equities as a whole are going up.

The article suggests the brokerage houses didn’t know their customer. I promise you, they knew, and knew the history of shady dealings. They just played a game of intellectual Twister, and talked themselves into some sort of rationalization because they wanted the fees and interest that go along with margin loans.

It’s possible they might not have known about how much the Huang family company owed to other houses on what stocks because they didn’t ask. Or it’s possible that they dotted that ’i’, but were given falsified financial statements. Another detail I’d love to know.

The numbers just aren’t big enough to affect the markets as a whole, so I’m not worried about a contagion.

And I disagree entirely with the article’s assertion that rises in interest rates could make the margin loans untenable. That happens only with declines in the value of the underlying stock.

It is possible that rising interest rates could erode stock values. But because rates are rising relatively slowly, and at a pace largely already priced in, we haven’t seen that yet.

This isn’t going away anytime soon, and I’m deadly curious to get details.

WSJ had a great "inside the meltdown" article ($$$) a few weeks ago...MS & GS looked out for themselves and, thus, got out before the others lost their shirts. Archegos' chairman Hwang lost $8b of his own money in 10 days. Wow. Moral of the story: If you're going to use or give leverage, you better be very prepared to lose most or all of it. This story reinforces the idea that "nobody knows nothing" in the markets - including those who have done well over many years and those on the inside.

"When Archegos called its banks for a meeting, they had different opinions on how to handle the situation.

Representatives from Credit Suisse and Nomura, which faced the most extreme losses, suggested working together over a month to unwind Archegos’s trades. They acknowledged the impediments to doing so, particularly that each bank would need to strike a separate agreement with Archegos to avoid antitrust issues.

Representatives from Morgan Stanley and Goldman Sachs balked at even the idea of doing so, saying that within a day or two the market would get wind of the amount of stock that needed to be sold and pummel them. The meeting disbanded before they agreed to work together.

The call ended Thursday night as the Asian stock market was about to open. The fire sale began."

 

[PA Tide Fan]

For those wanting to bet on inflation using a bond fund Vanguard has a short-term TIPS fund that YTD is +2.45%. It has a negative yield so all the gains are due to NAV increase.

 

[Bamaro]

Inflation outpacing money market funds and CD's is making it impossible to find a safe investment and protect principal.

 

[4Q Basket Case]

Inflation outpacing money market funds and CD's is making it impossible to find a safe investment and protect principal.

In the very short term (<3years), I agree.

Keep in mind, though: While the Fed controls very short term interest rates, it has as much control over longer term rates (a year or more) as you and I do — zero.

With $6 Trillion in economic stimulus, inflation is unavoidable. Inflation will inevitably drive up interest rates, but it will take some time for equilibrium to be re-established in the MM / CD / bond markets.

If you have a longer-term investment horizon (and if you’re not within 5 years of retirement, you should), a widely diversified equity portfolio is the way to go. That’s because, after a period of adjustment to the new discount rate, the value of stocks will rise with inflation.

IOW, stocks are how you protect yourself from inflation….which I agree is coming.

 

[UAH]

In the very short term (<3years), I agree.

Keep in mind, though: While the Fed controls very short term interest rates, it has as much control over longer term rates (a year or more) as you and I do — zero.

With $6 Trillion in economic stimulus, inflation is unavoidable. Inflation will inevitably drive up interest rates, but it will take some time for equilibrium to be re-established in the MM / CD / bond markets.

If you have a longer-term investment horizon (and if you’re not within 5 years of retirement, you should), a widely diversified equity portfolio is the way to go. That’s because, after a period of adjustment to the new discount rate, the value of stocks will rise with inflation.

IOW, stocks are how you protect yourself from inflation….which I agree is coming.

In the 80's and 90's I was involved in a Fortune 500's Pension Plan funding. Interest rates at the time were in the 11.5% range. I argued with our actuary that their plan interest rate assumption of 5% was grossly understated which established annual cash funding requirements for present and future liabilities of the plans. Those actuarial assumptions were true for most life insurance companies, banks, annuities which resulted in periods of excess cash flow that wasn't necessarily invested wisely considering AIG as one example of that. Now we are in a world of negative to zero interest rates with a sea of unfunded liabilities practically world wide.

In other words there is not a set of immutable facts when it comes interest rates and cash flow assumptions embodied in the equity markets over the long term and certainly no absolute certainty that the equity market will outperform bonds in the next twenty years as it has since 2000 when the Fed began dropping cash from helicopters.

 

[Bamaro]

In the very short term (<3years), I agree.

Keep in mind, though: While the Fed controls very short term interest rates, it has as much control over longer term rates (a year or more) as you and I do — zero.

With $6 Trillion in economic stimulus, inflation is unavoidable. Inflation will inevitably drive up interest rates, but it will take some time for equilibrium to be re-established in the MM / CD / bond markets.

If you have a longer-term investment horizon (and if you’re not within 5 years of retirement, you should), a widely diversified equity portfolio is the way to go. That’s because, after a period of adjustment to the new discount rate, the value of stocks will rise with inflation.

IOW, stocks are how you protect yourself from inflation….which I agree is coming.

IOW, if you are retired (or near it) you are screwed today.

 

[4Q Basket Case]

IOW, if you are retired (or near it) you are screwed today.

Not at all. And I am retired, just over two years now.

The trouble with talking heads and ink-stained wretches is that (1) they a have bully pulpit, and know how to use it, but (2) most have little to no understanding of money management. They also make their living off of ratings and/or clicks, so they tend to sensationalize what is really normal and predictable.

They treat money as a short term thing, and are generally slaves to the current trend, good or bad. As in, if it’s bad, the sky is falling and the future is going to look like 28 Days. If it’s good, we’re all going to be rich forever and can spend like drunk chimpanzees.

Money management and retirement planning is a long game. Markets go up and down, but it’s a sawtooth up.

So you have to take a longer view, and have cash or guaranteed income to bridge the inevitable downturns….which have happened since the Phoenicians, and will happen long after all of us are dust.

As BamaNation has said many times, it’s also a lot easier if you get started young.

— Get started young (like under 30, preferably under 25),
— Have a hard conversation with yourself on needs vs. wants,
— Put money in every single paycheck,
— Keep on keeping on, no matter what the news is saying,
— Diversify your investments,
— Don’t borrow or suspend monthly investment “just this once” to buy things that have no value once you get them home (clothes, household stuff, restaurant meals, vacations)
— Borrow as little as possible to buy things that depreciate (cars, motorcycles, boats, jewelry, etc.),
— For things that do depreciate, buy used. Let another guy take the depreciation hit.
— Pay extra on your home mortgage every month to get debt free

If you do all that, you’ll be able to retire comfortably even if you don’t have a six-figure job, and no matter what the Chicken Littles and Eeyores in the various media say.

 

[BamaNation]

As BamaNation has said many times, it’s also a lot easier if you get started young.

— Get started young (like under 30, preferably under 25),

E-X-A-C-T-L-Y! The alternative to starting early is saving a LOT more if you're older, which necessitates at least one of two things: much more income or much more savings (and not buying bling bling and identifying true needs/wants as 4Q points out).

Here's a rough guide from Ally.com. You can find similar guides with slightly different #'s but this is a pretty good guide, IMHO.

One popular age-based savings recommendation is that you should aim to save one times your salary by age 30 and increase your savings by your annual salary every five years.

By Age...	You should aim to have saved...
30	1 x your income
40	3 x your income
50	5 x your income
60	7 x your income
70	9 x your income
80	11 x your income

Keep in mind the above is more of a guide than a strict plan.




AND THEN THERE'S THIS ONE
Find the starting age at the bottom and your savings amount per year on the left. The interior of the grid tells you what age you'll become a millionaire. Long story short: The earlier you start, the easier it is to get there... but it's not impossible even if you're starting at a middle age.


The Million Dollar Age Grid - Four Pillar Freedom


How much do you need in retirement? Depends on what you want to do. Remember you can generally start withdrawing social security at 62 but are much better off (nearly 50% more benefit) if you can wait until 70). Do you have 401k? Pension? Other retirement income? Passive income? Inheritance? etc.?

4% safe withdrawal rate. A rough rule of thumb based on much research (Trinity Study and others) is that you can generally safely withdraw 4% (called safe withdrawal rate or SWR) of your 401k/IRA (or other retirement savings) from a 50/50 balanced fund starting at around 60 and not run out of money. To be more conservative, I like to think about 3% withdrawal rate and am gunning for 2% to be really safe.

4% means take the $$$ you want to withdraw and multiply by 25. That gives you how much you need to have in retirement savings when you retire. 3% would multiply by 33; 2% by 50. So if you wanted to use the 4% withdrawal rate to withdraw $40K per year, you'll need to have $1MM saved. 3% would require $1.32MM and 2% would require $2MM. Similarly, if you wanted to withdraw $100K, 4% would require $2.5MM, 3% requires $3.33MM and 2% requires $5MM in retirement savings .... and so forth.

Again, the earlier you start, the easier it is to get there. But all hope is not lost even if you're not 25 or 30 ... or even 50. Resolve today to get on the path noted by 4Q in his post just above this.

Fees. Fees. And more Fees! One thing to note: you have to factor in any fees you pay to your advisor as part of the % withdrawal, so if you're using a high-fee 2% advisor and want to use the 4% SWR then you'll give him/her 2% and you'll take 2%. Taxes and how risky are your sources of retirement income must also be factored in.

What a deal, huh? (for the advisor, at least!) This is why I passionately advocate for simple, DIY, passive, low-fee 3-fund plans or (even simpler) the low fee Target Retirement Funds that adjust the Fixed/Equity balance as you age. We follow the 3-fund plan and don't need active advisors screwing things up for us!

Want more info? Go back and read through this entire personal finance series to find out more!

 

[4Q Basket Case]

Personal finance encompasses a bunch of topics, and it can seem overwhelming if you try to understand the whole hairball at once. So I thought it might be helpful to address a few key concepts individually.

This post will cover making the most of tax-deferred accounts — 401Ks and IRAs.

Even those can get complex, so we’re not going to talk about things like “back-door” 401Ks, Roth vs. Traditional, etc. This is just the basics.

The big thing to remember about all personal finance is that technical knowledge isn’t the most important thing….knowledge of yourself is. Behavior trumps fancy product knowledge every single time.

That last sentence is really cool because it means anybody can do this, even if you don't know the difference between Roth and Traditional, or gross income vs. AGI, and even if you don't have a six-figure job.

Maxing out 401Ks and IRAs

401Ks

A lot of people brag at cocktail parties, cookouts and tailgates about maxing out their 401Ks. Often, they’ve contributed only the maximum amount their employer will match — usually anywhere from 3% to 6% of the base salary.

That’s a nice start, but for the vast majority of working schmos (and I was one), it’s nowhere near enough, and it's NOT maxing out a 401K.

Up to age 50, the federal government currently allows a maximum annual contribution of $19,500. At age 50, you can add what’s called a “Catch Up” amount of $6,500, for a total of $26,000. But this is aimed at younger folks, so we’ll concentrate on the $19,500 target.

$19,500 a year is what it takes to truly max out a 401K. I know that sounds so impossible that it’s not worth even trying. DON‘T THINK THAT WAY!

It is possible. Mrs. Basket Case and I did it. We had decent jobs but are far from wealthy. Here’s how we did it:

Step 1: Have an honest conversation about needs vs. wants.
You don’t need a new F150, or a trip to DisneyWorld, or a $500 driver, or dinners at the best restaurants. You might want them. You might envy people who do and who brag about them, and you want to brag yourself. But you don’t truly need any of that stuff, especially if you want to retire young enough to enjoy it.

So quit buying them.

Buy a used F150, stay at a beach hotel, keep the old driver, and cook at home (it's fun, and you'll be amazed at how much money you'll save).

Step 2: Start contributing. Suppose your taxable annual income is $60K. That means your marginal tax rate — the tax rate on your last dollar of income — is 22%. Now suppose your employer matches contributions up to 5%, and you get paid twice a month.

Given your new outlook on what you need vs. what you want, start contributing the most you can. A good place is 5% - 7%. More if you can do it.

Two really cool things happen.

First, at just 5%, you’re kicking in $3K a year or $125 per paycheck. But because your contribution isn’t taxable, your take-home pay goes down only 78% of $125, or $97.50, per paycheck.

Second, your employer is matching your $125 contribution.

So in exchange for foregoing $97.50 in take-home pay per paycheck, your 401K goes up by $250 per paycheck. Or $6K a year.

Sports fans, that's a return of 256% that first year. You can't beat that anywhere else.

Step 3: Increase your contributions. Like I said earlier, contributing the max your employer will match is a good start. But it's only a start. It's nowhere near enough. You're wanting to get your annual contribution up to $19,500. So how do you do that?

A couple of ways. First, after a few paychecks, your $125 contribution / $97.50 reduction in take-home just gets baked into your lifestyle, and you don't even miss it. And you'll find that you can bake a little more saving in, especially since it's costing you only 78% of your contribution. So if you can do 5% without noticeable pain, I bet you can do 6% or 7%. Admittedly, there's a limit to this source of funds. So.......

Second, you're getting raises. Increase your contribution by the amount of your raise. You started out with $60K in income. You get a 3% raise. That's $1,800. Or $75 a paycheck. Or $58.50 after Uncle Sam gets his 22% cut. You can barely buy a bottle of good bourbon for that.

But if you contribute your raise to your 401K, you're now at your original $3K annual contribution, plus the $1,800 raise = $4,800. Plus let's say 1.5% you managed to squeeze out elsewhere ($900). All it took was cutting back one round of golf per month. You're now contributing $5,700 a year -- or $237.50 per paycheck.

But remember.....because the contribution isn't taxable, your take-home goes down only 78% of that, or $185.25. Which still sounds like a lot until you consider you now have the higher income from your raise to help ease the pain.

More coolness: Your employer is still matching at 5% of your new higher pay, or roughly $3,100, as opposed to the $3K from last year. So in exchange for foregoing $185.25 per paycheck, your 401K is going up $8,800 per year -- A 197% return that first year.

No, it's not the 256% you got the first year you started. That's because you're now contributing more than your employer will match. But my goodness, guys, where else are you going to get anything anywhere near that?

Step 4: Keep on keeping on. NO MATTER WHAT. This is the hardest part.

You have to keep on putting all your raises into your 401k. You have to keep on contributing no matter what the talking heads in the media are saying. You have to keep on keeping on while your friends are buying new cars, bigger houses, and snickering at you for doing what you're doing.

That's OK, believe me, you'll get the last laugh. As Nick Saban says, "You will experience the temporary pain of disciplined behavior, or you will experience the permanent pain of disappointment. The choice is yours."

You're choosing the temporary pain of disciplined investing. Your friends will experience the permanent pain of disappointment.

It took the Basket Case household 7-8 years of sacrificing increases in take-home pay in order to truly max out the 401K. And it wasn't fun. But watching the rising 401K balance helped to ease the pain.

Even if the stock market is going down during some of this stretch, it's not a bad thing for you. It just means you're buying more shares at depressed prices. So when it turns up again (and it will), you're making a killing on all those cheap shares you bought.

Yeah, it’s a bit counter-intuitive, but when you're sitting on the edge of retirement, looking back at 30-40 years of work, you'll see that buying while the market was going down is where you made your no-foolin' money.

And I'm telling you, the feeling when you get that first raise that you can't put in your 401K because the rules won't allow it....it's fantabulously glorious. You can treat yourself and your family to something truly fun, totally guilt-free. Or, as was the case for us, we splurged on a trip to New Orleans, and invested the rest in IRAs.

Next topic: Maxing out IRAs.