An Incremental Approach

All too often, when people talk about retirement, they only talk in generalities (You should have a Roth IRA, invest in mutual funds, etc.). I am going to walk you through how I invest, where I invest, and give the reasons behind my decisions. The key to saving for retirement is knowing that, though the task seems insurmountable, if you take an incremental approach and understand each step you will retire without fear. In the US, wealth is a choice and not knowing how to save and invest is not a good excuse. Investing can be a very scary concept and not knowing where or how to start is one of the biggest issues most people face. I am going to try my best to ease some of those fears and show exactly how/where I invest my savings. Saving for retirement is not scary or daunting when you have a plan that you understand.

*Disclaimer* I am not a financial adviser or investing expert. I am merely explaining how I structure my finances. This is not a get rich overnight scheme … on the contrary, it is more of a get rich slowly, over many years, scheme…


Steps to Retirement

Below are the steps I take to save for my future, nothing fancy and nothing overly complex or time-consuming. 

  1. RUN FROM DEBT! Do not make purchases with debt! Do not take on more debt!
  2. Build an emergency fund!
  3. If your employer offers a retirement account match, contribute enough to get the full match
  4. Contribute to your IRA
  5. Contribute to 401k and/or TSP
  6. Contribute to any other retirement accounts
  7. Contribute to a taxable non-retirement account

(0) Giving

Giving is not one of the steps, however, the topics of generosity and charitable giving are particularly important to my life. My wife and I give 10% of our income to the church/charities right off the top. Even while paying off debt we gave 10%. Yes, giving considerably decreased the amount of cash used to pay off debt each month. Yes, it decreases the amount we can invest each month today, delaying our retirement significantly. However, supporting our local church and community is important to us and we want to learn to have generous hearts today and in our future retirement.

(1) Debt

This is probably the most important section of the post! Debt is ruining lives and the central cause of financial hardship for many Americans. There are many different schools of thought on good and bad debt, the use of credit cards, mortgages, school debt, and any other debt imaginable, some of which have merit and are worth your time researching. My stance is to run from debt at all cost and cash flow as much of life as possible. The only reason I take on debt is if the returns on investment were greater than the cost of taking on the debt (including a consideration of risk). Higher education often fits into this category but truly depends on the field of study, the job market, and/or whether a degree is actually necessary to increase salary. I would not take on $200,000 of debt for a degree in pottery but I would consider it for law school or medical school. People also forget to consider risk when making financial decisions. I opted into a new military retirement system, which potentially has a lower return over the course of my life, because it offers a significant reduction of risk. I gave up money, potentially over $100,000 over the course of my life, in order to ensure that I would get something in retirement rather than risk getting nothing. 

The following example exaggerates my point but you may be able to think of friends who have done exactly what I am describing. Taking on a $25,000 new car loan when you work in a volatile, $30,000/year job is hilariously foolish, and something I have seen done. Now the individual has a huge loan, 83% of their yearly income, looming without a guarantee of employment for the forseeable future. This is obviously crazy when you look at it from the outside but taking on a $25,000 car loan when you make $50,000 is not significantly different. Having any traumatic event in your life that causes your income to drop or disappear becomes a catastrophic event with such a large debt looming over your life. The worst part, people often take loans out on depreciating assets, meaning things that go down in value, such as cars. If you take out a loan on a depreciating asset you take a financial pounding in three major areas, the asset is losing money, the loan’s interest rate is adding to the overall cost, and you are missing out on the opportunity to invest that money.

Every dollar spent today is a dollar not saved for retirement, it is imperative that every dollar spent is done with that idea stapled to your forehead. A dollar invested today, assuming a 7% rate of return and ignoring inflation, is worth about $15 in 40 years. $15 is not a lot of money but when you talk about how the $30,000 spent on a car could be worth $449,234 in 40 years, it is a bit of a slap in the face. I use $30,000 as an example because the “average loan amount for a new vehicle reached a record high of $30,621 in Q4 2016”. If you assume a 4.21% interest rate on a car loan paid over 60 months with $0 down the total cost of your car is actually $34,010.33 or, if invested, half a million dollars that will not be in your pocket at retirement. Is that nice, new car worth it? Every time you take on debt, you are robbing from your future self.

*Future value calculator

*Loan calculator

I am not advocating living on nothing or never spending money. I am trying to persuade you to think about the opportunity cost of purchases. Before you make large purchases, especially when taking on debt, calculate (or at least think about) how much you are actually paying, given the terms of the loan, and ask yourself if it is worth the cost and worth missing the future value of that money in retirement. I often hear people say, “I can afford the car payment” as declaration that they can afford the $30,000 car purchased with debt. I want to make it abundantly clear that if you cannot afford to pay cash for the car today, you cannot afford the car you are driving. I am more than happy with my crappy $8,000 car and I will be extremely happy when I can afford a brand new car in the future, purchased with cash.

(2) Emergency Fund

An emergency fund is an essential tool for anyone working to end their paycheck-to-paycheck, debt-driven lifestyle. If you ask Google how much you should have in your emergency fund, the most common answer will probably say 3-6 months of expenses. The 3-6 month answer is an over generalized standard that may not actually meet your needs. You need to take into account risk when assessing how much of an emergency fund you need. I am in the military, a stable occupation, which is why my wife and I maintain a 3-month emergency fund. If I had a less stable occupation in conjunction with my wife’s unstable contracting position, we would have an emergency fund closer to 6-10 months. The goal of an emergency fund is to ensure that, when tragedy strikes or a job loss occurs, you do not have to rely on debt or credit cards to survive, which only increase the depth of hardship.

The next step is choosing how and where to keep an emergency fund. The whole point of an emergency fund is to have a pile of easily accessible money stored in a safe place for an emergency situation. For those reasons, using an investment account is not the place for an emergency fund. The volatility in the market could wipe out a large portion your savings right when you need the cash. An emergency fund is not for making money but provide security against catastrophic events. An emergency fund is a way to manage risk.

The best place for an emergency fund is a savings account where you get a small amount of return on your money without any risk of negative returns. The average bank’s savings account offers a hilariously low 0.06% average percent per year (APY) and can go as low as 0.01%. Low returns are acceptable for an emergency fund. The goal is not to make you rich but preserve the money. It is easy to get returns on a savings account as high as 1%, not great but still much better than a measly 0.06%. 

I have my emergency fund with an online savings account, Ally bankAlly offers a 1.2%  1.45% (UPDATE: 10 Feb 2018) APY, no minimum balance, a free checking account with checks, debit cards, and ATMs. This allows for a decent return (for a savings account) and immediate access to your money. I also like that it has a simple phone app for easy access.

Once the account is created, I set up automatic monthly withdrawals from my bank account, set for the day after payday, to ensure that I get my 3-month emergency fund established and funded as soon as possible. The nice thing about Ally is it allows you to set up automatic withdrawals that end once the account reaches a predefined balance. If you set up $1,000 monthly withdrawals and a limit of $15,000, Ally will only withdraw money from your bank account until the account reaches $15,000. Once you hit your goal, the account will pause automatic withdrawals, a beautiful set it and forget it method of saving.

My wife and I made it a top priority to get our emergency fund fully funded with about 3-4 months of expenses, prioritizing it above other retirement savings in order to fully fund it as fast as possible. It is also important to mention that the 3-4 months of expenses were based on monthly spending, not income. We budget for $4,500 of spending a month, which means that we need a minimum of $13,500 in our savings account, we rounded it up to $15,000 to provide additional security. The emergency fund is for anything from a car needing a quick fix, medical emergencies, a new refrigerator, or any essential need that unexpectedly occurs. Any money used from the emergency fund is budgeted for in the following month to replenish the fund, either with monthly installments or in full. The emergency fund is not for predictable expenses, such as, a new car next year, car insurance, taxes, an AC unit slowly going out, school books, etc. I budget and save for predictable expenses in a separate checking account.

Many do not know the how much their monthly expenses are or even have a good estimate. The first step is to begin either tracking expenses or, what I recommend, setting up a monthly budget and sticking to it religiously. My wife and I track our expenses month to month. We use the website Personal Capital to track expenses, which in my opinion is the best web application for tracking spending, investing, banking, and overall net worth. We also use a tool called Mint for budgeting, which is not the best budgeting app on the market but it is free and does an excellent job. Mint has a better phone app for budgeting but Personal Capital is much better at planning and tracking savings/investment accounts. I have not used but have heard good things about the  YNAB and everydollar tools for budgeting as well. 

Retirement Accounts

Retirement accounts are defined as any account that offers tax deferrals or tax-free growth, such as IRAs, TSPs, 401ks, HSAs, etc. that have a penalty for withdrawals made prior to reaching retirement age. 

I recommend contributing, at a minimum, 15% of your income to retirement accounts. Currently, my wife and I contribute closer to 25% of our household income to retirement accounts, which I hope will allow us to retire early someday.

(3) 401k Match

Many employers offer a match with their 401k/TSP programs. In 2018 the military rolled out the new Blended Retirement System (BRS) which offers a 5% match. I opted into the new system and will contribute a minimum of 5% of my base pay to the TSP for the remainder of my career. My wife currently gets a 3% match on her 401k and we have always elected to contribute enough to qualify for the match. It is hard to turn away free money and everyone should take advantage of the bonus.

It is important to note that employer/government contributions to 401ks and TSPs go to traditional 401k and traditional TSP accounts, as opposed to the Roth options. This means that the government collects income tax when withdrawals are made. If you withdraw funds early, before the age of 59 1/2, which you should avoid at all cost, there is a 10% penalty in addition to your income tax rate. 

(4) IRA

There are certain rules regarding who is allowed to contribute to a Roth IRA; you can learn the rules hereThe basics are, anyone who has an income, single filers <$118,000 and joint filers <$186,000, can contribute the full $5,500, for 2018, a year. That means a married couple could contribute up to $11,000 a year and a single individual can contribute up to $5,500 per year if their income is under the limit. If you are over the limit for a Roth IRA, you should contribute to a Traditional IRA.

Both Traditional IRAs and Roth IRAs offer significant tax advantages, which you can read about hereThe main advantage of a Roth IRA is the tax-free gains; taxes are due when the money goes into the Roth IRA as opposed to when it is withdrawn. In a Traditional IRA, the money going into the IRA is exempt from income tax, taxes are due when funds are withdrawn from the IRA. I use a Roth IRA with the assumption that I will be in a higher tax bracket in retirement. I have talked about this in another post; however, I will reiterate the example. Lets assume you are in a 10% tax bracket and contribute $1, tax-free, to a Traditional IRA and $1, $0.90 after taxes, to a Roth IRA. 

Year 0
Roth IRA Traditional IRA
Contribution $1.00 $1.00
Taxes (10%) $0.00 $0.10
Account Total $1.00 $0.90

Assuming your investment grows at 7% per year, they will have $15 in their Traditional IRA and $13.5 in their Roth IRA after 40 years. In retirement, if they are still in the 10% tax bracket and withdraw the entire amount the retiree will receive $15, $13.5 after taxes, from their Traditional IRA and $13.5, tax-free, from their Roth IRA.

Year 40
Roth IRA Traditional IRA
Contribution $15.00 $13.50
Taxes (10%) $1.50 $0.00
Account Total $13.50 $13.50

As you can see, if you remain in the same tax bracket, it makes no difference to which account you contribute. Assuming you are in a higher tax bracket at retirement you will see better returns in your Roth IRA because of the tax-free gains. I, in my late 20s, will contribute to my Roth IRA for the time being because I fully expect to be in a higher tax bracket in the future. I may consider using a Traditional IRA when I get closer to retirement or in retirement because my tax bracket will become closer to matching my retirement tax bracket, but that is for future me to figure out.

I can sum up the reason I put IRA contributions above 401k/TSP contributions in one word: control. In an IRA, individuals have control over all investment and management decisions of all the money in the account. Most employer 401ks have predefined funds that you may or may not agree with, potentially making you weary of your investments.

My wife and I have separate Roth IRA accounts, allowing us to contribute up to $11,000 per year. My Roth IRA is with Fidelity and my wife’s Roth IRA is with Vanguard. The only reason we use different companies is that I set mine up when I was a teenager and I set up my wife’s after we were married. We set each account to withdraw funds automatically from our bank account each month. Both companies withdraw the cash and invest it directly in our IRAs each month.

I invest 100% of my retirement savings in total market index funds, which is the laziest, most average, and best way to invest. My entire account with Vanguard is in VTSAX, VTSMX if there is less than $10,000 invested. My entire account with Fidelity is in FSTVX, FSTMX if there is less than $10,000 invested. Both of these index funds are essentially the same, they aredesigned to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks.” At a basic level, the funds both contain stock from all publicly traded companies in the US. When you own these funds, you are investing in the market average and your investments will never do better or worse than average. You will see the best returns for the lowest amount of risk.

Buying individual stocks is a great way to see huge returns on your investment, on the flip side, it is also a great way to lose everything. A single stock is a huge risk, the company could go bankrupt or worse the stock could plummet for no conceivable reason. Why risk your entire retirement savings on a single company? Rather than buying a microscopic slice of the pie, like buying an individual company stock, or a larger piece of pie, like buying an industry specific mutual fund, a total market index funds is buying the whole pie. If you are not going to listen to me, listen to the best investor of all time Warren Buffett.

Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund…To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them.

-Warren Buffett

In both my and my wife’s IRAs, I have money automatically withdrawn from our bank account on the 15th, payday, and invested directly into total market index funds. I use the total market index funds, instead of the S&P 500 index suggested by Mr. Buffett, because there is additional security in owning the whole market rather than the top 500 companies. In regards to the two companies, Vanguard and Fidelity , I prefer Vanguard for one simple reasons, the following quote comes directly from their website  explaining how they are managed/owned:

Vanguard is structured as a “mutual” mutual fund company. Our interests are completely aligned with those of our clients. We never have to weigh what’s best for clients against what’s best for the company’s owners, because they are one and the same.

Vanguard

I do not think you can go wrong choosing either company. They both have a terrific track record and have reasonable fees associated with their funds. Vanguard‘s fee for VTSAX is 0.04% as opposed to Fidelity ‘s FSTVX at 0.035%, both are rock bottom.

It is important to think about fees when choosing investments because fees as low as 1% can erode more than 23% of your gains over the course 30 years. That 1% fee really compounds over the years. This image is from Personal Capital to demonstrate how a 1% fee hurts an investment over time:

Investment Fees

Fees and fund selection are the sole reason I will not recommend anyone use any bank other than Vanguard or Fidelity. I know that many, especially those serving in the military, use USAA for all banking needs, including Roth IRAs. When I began my research into investment accounts years ago, I stopped my USAA contributions and opened up a Roth IRA with Vanguard. USAA is a great company and I will bank with them for the foreseeable future. However, it is possible to do much better when choosing an investment account, especially for retirement accounts, and their savings accounts are, similar to most banks, laughably worthless.

My wife and I try to contribute as much to our Roth IRAs as possible, invest in the total market to reduce risk, minimize fees as much as possible, set up automatic investment ($458.33 a month to max), and never touch the account. It is important to continue contributing and investing when the stock market is high and when the stock market is crashing, set up automatic bank withdrawals and automatic investigating and forget about the account. Never stop contributing!

(5) TSP/401k

I have a TSP and my wife has a 401k, which is better? Which should I contribute to first? I made the conscious decisions to contribute as much as possible to my Roth TSP prior to contributing to my wife’s 401k for a few reasons.

I use total market index funds for my retirement, those are the funds discussed previously that I have with Fidelity and Vanguard. The TSP does not specifically offer a total market fund; however, using a combination of the C fund and S fund I can achieve a total market fund, as close to one as possible. I contribute 80% to the C fund and 20% to the S fund to model the total market. You can see my explanation of the TSP funds here. There is a valid argument to be made regarding the inclusion of the I Fund (international) in the diversification. If you choose to include the I Fund to get international exposure I recommend a 70% C Fund/15% S Fund/15% I Fund distribution. 

contributionallocation

I always choose a Roth investment over a Traditional. My wife’s 401k does not offer a Roth 401k option and the Roth TSP allows me to ensure that our future gains are tax-free, as discussed above.

Her 401k’s funds are both not as good as and are more expensive than any fund in the TSP. My wife’s 410k offers plenty of funds; however, when you look at their historical returns and fees they barely keep up with average market returns, if at all. I have 100% of my wife’s 401k in an S&P index. Some of the 401K funds have fees as high as 2% with average long-term returns less than 6%! The TSP offers an incredibly low fee of 0.038%.

Of all of our retirement accounts, we contribute the most to the TSP because the max contribution limit of $18,500. We can max out the IRA’s $5,500 limit each year, but it is much more difficult to max out the TSP. We contribute the least to the 401k because of the weak funds offered. My wife’s company does offer a small 401k match so we contribute, at a minimum, 3% of her income. Once my wife leaves her current company we will roll that 401k over to an IRA.

Side note: Every time you leave a company, roll your 401k over to an IRA. As stated previously, it gives you full control of how to invest and manage the money. Do not take the money out of the 401k. Always roll 401ks into an IRA. Very different, very important. 

(6) Alternate Retirement Accounts

Unfortunately, I do not have access to other tax deferred or tax-free growth accounts. However, if I had access to something like a Health Savings Account (HSA), 457(b), or another type of account I would contribute to it after the previously discussed accounts.

Non-Retirement Accounts

I recommend contributing, at a minimum, 15% of your income to retirement accounts and as much as possible to non-retirement accounts. My wife and I contribute closer to 25% of our income to retirement accounts and make a goal to contribute another 30% to taxable, non-retirement investment accounts. That amount fluctuates based on how much we want to spend on vacations, gifts, and any other luxury purchases.

Update: I have received a few questions regarding my thoughts on real estate. The fact is, I do not plan to buy a home or any real estate while in the military. I do not have anything against real estate but do dislike the amount of hassle that goes into owning property. I take the lazy approach to investing. Therefore, for the foreseeable future, I will stick to total market investing rather than owning real estate. If you are interested in real estate as an investment, it is a worthy endeavor.

(7) Investment Account

My wife and I have our joint investment account with Vanguard where I invest in same manner as my IRAs. I invest nearly everything into VTSAX, VTSMX if there is less than $10,000 invested. Additionally, I contribute around 1-2% to VBTLX, VBMFX if there is less than $10,000 invested, which is Vanguard‘s total bond market index fund. The goal of VBTLX is to provide broad exposure to U.S. investment grade bonds. Reflecting this goal, the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues).” Essentially, it is the bond version of Vanguard‘s total stock market index fund, VTSAX. The only reason I contribute to the bond fund is to buffer my emergency fund. I will only invest enough into the bond fund to get closer to 8-12 months of expenses, not a true emergency fund, but a more stable fund that will provide some additional security. 

One of the reasons this is called a non-retirement account is because the money in this account is not strictly meant for retirement. The accounts are meant as savings for anything I plan on purchasing 8+ years from now. I am using this account to save for a future house, cars, kid’s college (I’ll talk about kid’s college in another post), and retirement. This is a universal savings account for all future purchases. Currently, my investment accounts is looking pretty sad because I only recently completed my emergency fund. Meaning, I am only just beginning to contribute to my non-retirement account. But, I look forward to seeing it grow.

An Incremental Approach

Wealth is not something achieved overnight, nor is it achieved using pseudo secret techniques that you hear or read about on the internet. Wealth is attained the old fashion way, hard work and patience. Building wealth is done $1 at a time and if you take an incremental view of things and contribute as much as you can, even in small amounts, it makes a huge difference.


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