Let’s Stop Choosing!
We’ve never been shy to share the many financial mistakes we’ve made. Most have been related to investing and tax planning. These topics were very confusing and so we threw our hands up in the air.
Investing and Taxes Simplified
The first person who really simplified investing for us was the blogger Jim (JL) Collins. The single take home message I learned from reading his Stock Series is that investing should be simple and inexpensive.
The first person who had this effect on our understanding of tax planning was the blogger Brandon aka, “The Mad Fientist”. He teaches that the best tax planning strategy available to a worker looking to retire early is to defer all possible taxes. This limits taxation during your highly compensated working years by recognizing your income gradually over many years when it will be taxed at far lower rates.
Choose a simple, low cost investing strategy and limit your tax burden and you’re well on your way to success.
So here is the problem. The best option that any worker has to defer taxes is to utilize his work sponsored retirement accounts (401(k), 403(b), SIMPLE IRA, etc). However, using these accounts limits your investment options to what is included in your particular plan, which are often overpriced mutual funds.
In Part VIII-b of his stock series, Collins questioned whether we should even utilize these work related plans. This is because they have in many cases become, to quote him, “a cesspool of fees”. However, Brandon in an addendum to this post, presented his analysis of the tax benefits of using the plans. He determined that the benefits almost always outweigh the detrimental effects of the fees.
When either of these guys write something I read it and pay attention.
However, when I think about what we as the FIRE community are doing to use our finances to build a better way of life, I hate the idea that we need to settle. It is simply not our way.
Conventional wisdom says early retirement is extremely difficult. Paying for your kid’s college is expensive and extremely challenging. We’ve highlighted the plan of Go Curry Cracker to pay for their child’s college education, fully funded before he was born and they were retired in their 30’s.
For most people, housing is their largest expense. We had Chad Carson share his path of real estate investing in a guest post. One of his strategies is “house hacking”. He eliminated this expense, provided a place for his family to live, and made a few extra dollars every month.
The average person struggles to figure out how to pay for a week or two of vacation each year. The FIRE community is full of people who have taught me words like “travel hacking” and “slow travel”. They manage to travel the world while saving 50+% of their income and then continue to travel in retirement.
So when it comes to this critical investing decision why are we willing to choose? We weren’t and so we dug a bit deeper.
Defining the Problem
The problem, as we see it, is that because of overcomplicated tax laws, our investment options were being placed in the hands of our employers. Business owners and managers are generally not educated to make good investment decisions. They are often too overwhelmed by all that goes into starting, growing and developing their business to worry about these decisions for themselves, let alone meet the needs of all of their employees.
However, because of our tax laws, their decisions can have major impacts on our finances. The often uninformed decisions of our employers then hold us hostage to the options made available in a particular plan.
We have found that the best way to get what we want from any situation is to help the other side win. With this situation, that is pretty easy due to one word: nondiscrimination. As described by the IRS:
Nondiscrimination – To preserve the tax benefits of a (retirement) plan, the plan must provide substantive benefits for rank-and-file employees, not just business owners and managers. These requirements are called nondiscrimination rules and compare both plan participation and contributions of rank-and-file employees to those of owners/managers.
There is a lot of legal/technical mumbo jumbo involved in testing if a plan meets the nondiscrimination criteria, but on a big picture level what this means is that if you have a plan that sucks, your employer’s plan also sucks. There can not be a good plan for the haves, and bad plan for the have nots.
Why would your employer choose a lousy plan for employees, if they are then also stuck with it? Well as we have found out with our own personal investing history, most investment products are sold and not bought.
Simply educating the right people and offering to help solve the problem, we have been able to help our employers (WIN!) which in turn helps us (WIN!). Bonus: When you are successful in changing these plans, every one of your co-workers who participate benefits. (WIN!)
The only people that lose in this deal are those in the financial industry that make their living by burdening us with unnecessary, hidden fees. Regular readers of this blog know I’m not losing sleep over them.
Case Study 1
I have worked with my company for over 10 years. During that time, I always contributed 5% of my salary to receive a 4% employer match. Then after starting to read “FIRE” blogs, I started maxing out my contributions. This left me with a healthy 6 figure balance in my 401(k) account.
When investigating my plan, I found it was pretty average. However, it was worth my while to try to make it good. If I could lower my expenses by even 1/2 of a percent annually, it would save $500 for every $100,000 invested every year. Save 1% in fees and I would save $1,000 every year without taking any effort or sacrifice. This saving would then become even more significant as the money continued to compound.
I simply approached my boss and started a conversation as to how we got the investment options that we had. I could tell that it was something that he had given little thought. He told me that he had read an article about index investing but didn’t fully understand it.
The next day, I gave him the John Bogle book, “The Little Book of Common Sense Investing“. I followed up with him every week or two, seeing the book sitting on his desk and knowing he hadn’t looked at it. I then reminded him gently that it was an easy and interesting read before I knew he was flying across the country for a golf trip and would have the time to read it.
When he returned from the trip, he gave me the book back and told me he was going to talk with our 401(k) providers. Within the month, we got a memo that we would be having new options added to our plan.
Prior to the change we had only two indexing options, a large and mid cap fund with respectable expenses of .43 and .41% annually. After the changes, we had the Vanguard 500 index and Mid-Cap index funds with expense ratios of .05 and .09% annually.
Our small cap options improved more dramatically. We had no indexing option before and so I had to choose between two active funds charging 1.19 and 1.11%. After the changes, we had the Vanguard Small Cap Index Fund at .09% annually.
Prior to the changes our options for international funds were both actively managed funds charging 1.26 and 1.18% annually. After, we added the T. Rowe Price International Equity Index at .45%.
We previously had no REIT option. After the changes, we added the Vanguard REIT index (ER=.26%).
Taking the time to have a 20 minute conversation and loan out a $20 book for a couple of months was worth over $1,000 annually (and ever growing) for me. I was now able to build a portfolio in line with my investing philosophy. I also got the positive boost of knowing my actions helped everyone in my company.
Case Study 2
Mrs. EE switched jobs about 2 years ago. She took a very generous job offer that included the ability to work from home, part-time with generous compensation and benefits. The only downside was that the retirement plan was not as good as at her prior job. Once it was time to enroll, we realized it was REALLY AWFUL!
She went from a 403(b) at her old employer to a SIMPLE IRA. This change alone meant that she could max out at only $12,000/year instead of $18,000. This difference means an extra $6,000/year of taxable income. At a tax rate of 25%, this is an extra $1500/year going to the government instead of staying in our investments and working for us.
Then the investment options were horrible. This was a bit ironic because there were well over 60 funds available to choose from. After sifting through the choices, we couldn’t find one single fund that fit with our simple indexing strategy. So we contacted the plan advisor. He informed us that we could have even more choices, including our chosen Vanguard funds. However, we would have to pay a 1% advisory fee to be able to choose these funds.
Luckily, the good people at the Boglehead’s forum shared this way to work around a bad SIMPLE IRA plan. We followed this plan and rolled her contributions over monthly to a SIMPLE IRA we opened at Vanguard.
While this saved us substantial fees, it was a headache to manage and monitor and still didn’t take care of the tax issue. I pushed Mrs. EE to discuss this with her employers. She was nervous to ruffle feathers, considering that she was new and had such otherwise stellar working conditions.
When they had their company meeting about this time a year ago, her employers asked for any suggestions to improve working conditions. Mrs. EE put aside her inhibitions and spoke up and explained (gently) how bad the retirement plan was.
About a week later, she got a written thank you from her employer for having the initiative to speak up. These new business owners genuinely wanted some employee constructive feedback and she was the only one to give any! (Maybe another example of why we all need F- You money, even if we have no desire to ever actually say F- You to anyone.)
The employer followed up and asked her a bunch of questions about what investment options she was looking for and asked her about our investment philosophy. In December, she received an e-mail alerting her that her company was switching to a 401(k) plan for 2016. We found an awesome plan with a number of excellent investment options.
Her employer is happy. We benefit along with everyone in her company.
In personal finance, you will face many technical challenges along the road. It is often very easy to throw up our hands and not try.
We would love to see our overcomplicated tax laws change. We would love to see real reform in our predatory financial industry. I don’t see any immediate hope of those things happening.
However, looking for things we can change can have massive, immediate impacts with minimal efforts. In this case, we knew we couldn’t change the system, but we could find ways to work within it to our benefit.
In my case, I spent less than an hour total between the inital and follow up conversation with my employer. This effort saved me over $1,000/year in ongoing, unnecessary fees.
In Mrs. EE’s case, she spent an hour or two talking and exchanging e-mails with her employer and she will now be able to eliminate $1,500 in federal income tax alone every year. She will also simplify her investing process and cut the already low investment costs of the Vanguard SIMPLE IRA by about 75%.
Our path to financial independence has taught us how to be better investors and tax planners. However, far more important, this path has taught us that you don’t necessarily have to make choices (or work harder or sacrifice, etc) just because conventional wisdom says we do. Let’s stop choosing!
Have you had similar success with changing your retirement plan options or are you caught in the tax advantaged vs. low cost investing dilemma? Anyone ever try to do what we’ve done in a larger company? If you haven’t tried to fix this problem in your company, who are you waiting for to do it? Please share your thoughts below.