Personal Finance 101

This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Agenda

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Personal Finance 101

Investing Thoughts

This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Personal Finance 101

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This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Bird’s Eye View of Personal Finances - Intro

• A couple great resources:
• Bogleheads® personal finance planning start-up kit
• General Financial Planning Overview

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• Ahead of diving into the world of retirement saving & investing, it’s important to...

Take care of Basic Steps

Establish a broader Financial Plan

• Do you track your expenses and maintain budgets?

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• Do you have an emergency fund (e.g. 6 months of living expenses, unexpected medical costs for you or family reliant on you)?

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• Have you paid down bad debt (e.g. 20% interest rate credit card)?

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1. Day to day finances (budgeting, expense control, mortgages, other debt, emergency funds, etc.)�
2. Investments/Retirement (401(k), IRA, Non-retirement accounts)�
3. Insurance (life, health, disability, property)

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Why Should I Save for Retirement?

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• Let’s assume your income grows 3% annually from ~$80k at Age 25 to a bit over ~200k at Age 60
• By saving (and not spending) 15% of your annual income you can maintain your standard of living in retirement
• Additionally, you may still have a significant amount of assets left to bequeath to your family

If you don’t save anything, retirement is going to be very financially stressful

The area between these curves is the 15% of your annual income you’re saving for retirement

It would be highly unfavorable to have zero assets going into retirement

Annually saving 15% of your income will allow you to have close to $2.5M going into retirement

Savings Priority Order

6-Month Rainy Day Fund

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Let’s say the average cost of this debt is 5-10% interest rate → Every dollar of debt paid down is 5-10% in GUARANTEED return

Store 6 months of expenses in a high-yield savings account → At places like Ally Bank you can expect ~0.5-5% return (varies based on govt. rates)

Try to contribute a sufficient % of your income to your 401(k) account to maximize match from your employer (i.e. on average, employers tend to match 3-5% of your cash income)

Backdoor Roth IRA

→ 5-7% market return

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Mega Backdoor Roth

via Company 401k

→ 5-7% market return

Pay off car, student, credit debt

1

Roth Retirement

5

Pre-Tax 401(k) to maximize

your company match

Order of Savings by Priority:

3

Try to save up to a total of $23,000 (which is the 2024 government limit) in your 401(k) account → 5-7% market return

Pre-tax 401(k) to reach

$23,00 government limit

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4

Savings Priority Order - CAVEAT

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“Time in Market” > “Timing the market”

• Any money you invest into the stock market you should plan to leave untouched for at least 5 years (and preferably 10 years). As such, unless you're a few short years away from retirement, there is minimal value in TRYING TO predict stock market crashes/corrections. You will end up hurting (more than helping) yourself. But what if I only invested in market peaks?

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$$ required for near-term big life expenses should not be invested in the stock market

• If you foresee big expenses (down payment on a house, children, medical expenses) in the next 5 years, that money should be very carefully considered. Would not recommend investing it into the stock market (or put into a 401(k) or IRA). As the stock market guarantees safe return over medium term periods (i.e. 5-10 years and beyond). But in the shorter term, it can be volatile.

What is Taxable Income?

Components and Deductions

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Every individual get a standard government deduction of $12k ($24k for couples filing jointly)

Contributing to a Traditional 401(k) provides an additional deduction

Contributing to a Roth IRA is done on an after-tax basis → No impact on Taxable Income

How is Taxable Income… taxed?

It’s progressive (updated for 2021)

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As a Single Individual:

• Your first $9,950 in taxable income is taxed at 10%
• Your next band of taxable income ($9,950 to $40,525) is taxed at 12%
• Your next band of income ($40,526 to $86,375) is taxed at 22%
• And so on...

• But, don’t forget, the government lets you take a standard deduction, which helps reduce your taxable income

Beyond Federal Taxes… what else do I pay?

State Income | Social Security & Medicare (updated for 2021)

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How is Taxable Income… Taxed?

It’s progressive | Simplified example

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All income in this band is susceptible to 22% Federal Taxes

All income in this band is susceptible to 24% Federal Taxes

Let’s say you make $80k

This $20k (from $60k to $80k) is charged 22% in taxes. So ~$4.4k.

This $20k (from $80k to $100k) is charged 24% in taxes. So ~$4.8k.

Let’s say you make $100k

This $20k (from $60k to $80k) is charged 22% in taxes. So ~$4.4k.

Taxes

How does a Pre-tax 401(k) impact taxes?

It provides a deduction today but you need to pay taxes in retirement

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All income in this band is susceptible to 22% Federal Taxes

Let’s say you make $80k

This $20k (from $60k to $80k) is charged 22% in taxes. So ~$4.4k

Now let’s say you then save $19k in a Pre-tax 401(k) account

You now reduce your taxable income from $80k to $61k. Your tax bill in this income band becomes just $1k * 22% = $220 → You saved ~4.2k in taxes upfront.

So what’s the catch???

When you withdraw from your Traditional 401(k) in retirement, you will PAY INCOME TAXES

Taxes

How does a Roth 401(k) or Roth IRA impact taxes?

It provides no deduction today but tax benefits in retirement

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All income in this band is susceptible to 22% Federal Taxes

Let’s say you make $80k

This $20k (from $60k to $80k) is charged 22% in taxes. So ~$4.4k

Now let’s say you then save $19k in a Roth Account

Nothing changes because Roth account contributions are made on an after-tax basis. Your tax bill remains ~$4.4k.

So what’s the point of a Roth account?

When you withdraw from your Roth IRA in retirement…

YOU PAY NO INCOME TAXES!

Taxes

What’s the point of Retirement Accounts? Traditional 401(k) & Roth 401(k) / Roth IRA → You avoid Double Taxation

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Employer Pays You

$12.5k

$12.5k

Investing using your regular after-tax income

Pre-tax

401(k)

Roth IRA

You Pay

Government Today

~20%

Income Taxes

Leaving you with...

$10K

You Invest

(assume 25 yrs

@ 7% growth)

~$55k

You Pay

Government in Retirement

~15% Taxes on Investment Gain ($45k)

Leaving you with...

$48K

You contribute $12.5k to Traditional 401(k)

$12.5K

This $12.5k is pre-tax deducted from your income so you don’t have to pay any taxes on it

You choose to invest this $10k

$10K

~$68k

~20% Income Taxes on Full Amount ($68k)

Leaving you with...

$55K

~20%

Income Taxes

$10K

You choose to invest this $10k in a Roth account

$10K

$12.5k

Leaving you with...

~$55k

No Taxes Due

Leaving you with...

$55K

Taxed Twice!

Roth

401(k)

How can I project my own retirement accounts into the future? Glad you ask....

An intentionally basic calculator to estimate how much you'll have saved in retirement based on your contributions during your working years.

You only have to update the yellow-shaded, blue font cells, which represent basic inputs like your income, 401(k) contribution rate and Roth IRA contribution amount.

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Downloadable copy available upon request | uspersonalfinance@gmail.com

Link to resource

Knowledge Check on Retirement Accounts

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Retirement Savings & Withdrawal

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Today (assume 25% marginal tax rate)

$10k

Retirement Age (assume 25 years from Today, 7% growth)

Contribute $10k to pre-tax 401(k)

Traditional 401(k)

$54k

Tax Rate

Marginal Income

Tax Rate

Withdrawal Order in Retirement

to limit Taxes

1st

2nd

By making this your 2nd source of retirement funds, you will prolong tax-free growth of retirement funds. Roth IRAs can also be bequeathed to your descendants tax-optimally.

Withdrawing from Traditional 401(k) accounts positions you well to reduce your tax exposure when Required Mandatory Distributions (RMDs) kick in around age ~70

* In addition to your Traditional 401(k) and Roth IRA accounts, you will hopefully have funds in a standard after-tax brokerage (taxed at long term capital gains rate, currently 15%) and Social Security (taxed at marginal income tax rate)

$10k

Contribute $10k to a Roth account

Roth IRA

$54k

0%

Roth

401(k)

Investing Thoughts

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This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Investing Thoughts

Simplicity is the master key to financial success. When there are multiple solutions to a problem, choose the simplest one.

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— Investing With Simplicity, John Bogle (founder of Vanguard, the largest passive-fund manager in the world with $3.8 trillion in assets)

My money...is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will… Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals—who employ high-fee managers.

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— 2013 letter to Berkshire Hathaway shareholders, Warren Buffett (Arguably the most successful investor of all-time)

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Dr. Passivelove or: How I Learned to Stop Worrying and Love The Market

Inspiration: https://jlcollinsnh.com/2012/04/19/stocks-part-ii-the-market-always-goes-up/

Dow Jones Industrial Average over 100 Years

Time Magazine, 1987

... It wasn’t.

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$1 invested in 1988 would have turned into $20 by the end of 2018 30 years later.

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The Market Always Goes Up!

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Friends don’t let friends time The Market. And, no, the world is probably not ending.

Every generation imagines itself to be more intelligent than the one that went before it, and wiser than the one that comes after it.

• George Orwell (Author of 1984)

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A Case Study in Active Investment Management

Report: Apocalypse Actually Happened 3 Years Ago

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MENLO PARK, CA—Though the event went largely unremarked upon at the time, a report published Monday by the Kaiser Family Foundation has found that the apocalypse, or end of the world, occurred three years ago. "According to our data, the total collapse of all human civilization occurred on or around April 3, 2008," said foundation representative Jodie Palmenterri, citing numerous instances of environmental disaster, humanitarian catastrophe, and economic ruin as unambiguous signs that the world had ended. "Those who have worried for years that human culture was headed toward calamity can rest easy, because it already happened. We are living in a post-apocalyptic world. This is it." Palmenterri went on to say that because the apocalypse does not resemble the eschatological predictions of any major religion, it's safe to assume the gods have all forsaken us.

But… I believe I can beat The Market

Inspiration: http://www.aei.org/publication/more-evidence-that-its-really-hard-to-beat-the-market-over-time-92-of-finance-professionals-cant-do-it-2/

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“It’s really hard to ‘beat the market’ over time, ~92% of finance professionals can’t do it”

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Even slightly beating the Index year after year is vanishingly difficult. Only a handful of investors have been able to modestly outpace it over time. Doing so made them superstars… see: Warren Buffett.

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Real Estate vs. The Market

1. Debates on Real Estate vs. Stock Market investing perpetually rage on in personal finance communities. People have utilized one or both to create immense long term wealth. �
2. Side-stepping the debate (both are great investment options), here are a couple differentiating points:

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1) Real estate: requires moderate management due to maintenance, conflicts with neighbors, and tenant rotation. Property managers can be mitigants. However, they charge a material % of rents and are not strictly aligned with you on managing down the costs of maintenance.

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2) Stocks/Bonds Portfolio: can literally be left alone forever. You can easily automate the purchase of passive index funds (with <0.05% expense fee) through our 401(k). You can spend less than 1 hour a month on average to manage your portfolio. Without maintenance you’re able to focus your attention elsewhere such as spending time with family, your business, or traveling the world.

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… but, for some, the leverage-boosted returns of carefully chosen/managed real estate is worth the effort.

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Appendix - FAQ

This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Withdrawing Retirement Funds Early

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• Contrary to popular belief, money invested in 401(k) and IRA accounts are not unconditionally locked up till retirement (e.g. direct contributions to a Roth IRA are withdrawable at any time)

Pre-tax 401(k)

Working at Employer

Contribute $X from paycheck on pre-tax basis, which grows to $Y with market returns

Post-Employer

Rollover $Y to a Roth IRA (considered a taxable conversion). Can only do Post-Employer.

Wait 5 tax years

Allowed to access $Y total funds

Mega Backdoor into Roth 401(k)

Working at Employer

Contribute $X from paycheck on after-tax basis via Mega Backdoor into Roth 401(k), which grows to $Y with market returns

During or Post-Employer

Rollover $Y to a Roth IRA at any desired time during or post-Employer

Allowed to access $X contributions

Immediately

How does early withdrawal from the Roth IRA work?

Source: https://www.irs.gov/publications/p590b#en_US_2018_publink1000231071

How does early withdrawal from the Roth IRA work?

1) DIRECT CONTRIBUTIONS

If you make under $122k (filing single) or under $193k (married filing jointly), you can directly contribute $6,000 annually. You are allowed to pull these contributions out at ANY TIME (no waiting period).

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2) TAXABLE CONVERSIONS

If you convert funds from a pre-tax 401(k) to a Roth IRA, you will recognize the converted amount as taxable income in the year of conversion. However, these funds will be available for early withdrawal AFTER 5 TAX YEARS. This is what you're thinking about when it comes to early non-penalized withdrawal from a Roth IRA.

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3) NON-TAXABLE CONVERSIONS

If you move after-tax 401(k) funds to your Roth IRA, the initial after-tax CONTRIBUTIONS (i.e. the amount you allocate as post-tax deduction from your paycheck), you are allowed to pull these contributions out at ANY TIME (no waiting period).

When early withdrawing from the Roth IRA, the IRS mandates a certain order of withdrawal...

When you start thinking about withdrawing from your Roth IRA early. Per IRS rules, the order of withdrawal needs to be:

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1) DIRECT CONTRIBUTIONS made while your income was within the IRS allowed limit.

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2) CONVERSIONS such that you have to withdraw 'conversion' funds in order of earliest year of conversion into Roth IRA. And even within a single year's 'conversion' funds the taxable conversion funds (for which you need to wait 5 years to avoid the 10% early withdrawal penalty) have to come out before the non-taxable conversion funds (which can be withdrawn at ANY TIME).

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3) GROWTH which is any investment return you made within a Roth account (whether it be a Roth 401(k) or Roth IRA). This is always susceptible to tax and a 10% penalty if it's withdrawn before retirement age.

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As you can see, you need to really carefully think about how you funnel money into your Roth IRA, if you plan to withdraw funds prior to traditional retirement age.

Roth IRA Distribution Ordering Rules

The IRS has prescribed a distribution hierarchy for Roth IRA assets.

1. Contributions are always taken first;
1. Contributions are always distributed tax and penalty free
2. Conversions (if any) are second in order by year of contribution, with converted pre-tax assets taken first and converted after-tax assets taken second.
• Converted pre-tax assets are distributed tax and penalty free as long as they have been held in the account for five years. If not, a 10 percent would apply to the distribution.
• Converted after-tax assets are always distributed tax and penalty free.
3. Earnings are considered distributed last.
• Earnings are distributed tax and penalty free if the Roth IRA has existed for five years and the distribution is done on or after age 591⁄2, or following death, disability or first-time home purchase. Otherwise the earnings would be taxable and subject to penalty unless a penalty exception applies.

Let’s say you do the Mega Backdoor into your Roth 401(k). How does early withdrawal work?

On Friday (paycheck day):

+ You allocate $50 as an after-tax 401(k) contribution

+ You have in-plan daily Roth conversion activated

+ By Monday, employer will move over the $50 to your Roth 401(k)

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Let's flash forward to movement of these funds from your Roth 401(k) to your Roth IRA to facilitate early withdrawal:

+ Your initial $50 has grown to $100

+ $50 will be considered NON-TAXABLE CONVERSION/ROLLOVER into your Roth IRA, as it represents your initial after-tax 401(k) CONTRIBUTION. This can be withdrawn immediately, no 5 year wait / no 10% penalty!

+ The $50 of GROWTH would be susceptible to marginal income taxes and a 10% penalty if withdrawn prior to traditional retirement age (59 ½)

Appendix - Detailed Information

This material IS NOT an official source of financial or legal advice. Please proof-check all the facts by yourself and/or consult a financial and tax adviser as needed.

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Some slightly more complex follow-up

• How do I think about the Stock Market?

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• What is a Traditional Backdoor?

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• What is a Mega Backdoor?

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• How to Access Retirement Funds Early