Roth Accounts Are A Scam For Those Seeking FIRE

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation.

This will be my third post in this series on Traditional vs. Roth accounts, but hopefully it will be the most enlightening on the superiority of Traditional accounts over Roth accounts for those seeking FIRE. If you haven’t read my two prior posts on this subject, then go back and check them out for some background. In this post, I highlighted the differences between the accounts as well as the reason why today’s marginal tax savings must be compared to effective tax burden in retirement. In this post, I concocted a real world example comparing two individuals with exactly the same income and expenses to show how a traditional account will come out ahead.

Let’s layout, what I would consider to be, a fairly typical financial situation for someone seeking FIRE. Like earlier posts, I will use a single individual with no kids for simplicity sake, but the same ideas and similar calculations would apply for those married with kids. I also am going to assume that inflation, raises, and expenses all rise in a proportionally equal manner to make the calculations more simple. This individual, Steve, has a salary earning $36,000/year, putting him in the 15% marginal tax bracket. His total expenses are $18,000/year, which he intends to keep the same throughout his retirement, tax adjusted of course. At his workplace he has the option of contributing to a Roth 401k or a Traditional 401k, and he is trying to decide which will be the best option for him and will allow him to reach FIRE as soon as possible while investing the $18,000 difference between his income and expenses. A 50% savings rate may seem high, but for those seeking FIRE this is fairly common. Steve is starting his FIRE journey at the age of 39 after recently paying off all of his credit card debt, and he now has a total net worth of exactly $0. He knows that with a 50% savings rate he will be able to reach financial independence in about 16 years, at which time he will be 55 years old and able to withdraw money from his 401k (whether traditional or Roth) without a 10% penalty. Let’s start by looking at what his current tax burden will be with each type of account to try to gain some clarity on the situation. Here are the current tax brackets from reference.

2017 taxes brackets

Traditional 401k

If he chooses the traditional 401k and invests the full $18,000 each year, here is what his tax burden will look like:

  • $36,000 – $18,000 (Traditional 401k contribution) = $18,000
  • $18,000 – $10,400 (Standard deduction and personal exemption) = $7,600
  • $7,600 * 10% (Marginal tax bracket) = $760

His total tax burden will be $760/year for an effective tax rate of $760/$18,000 = 4.22%.

His total tax savings each year from contributing to a traditional 401k in this example is:

  • (($9,325 – $7,600) * 10%) + ((($18,000 – ($9,325 – $7,600)) * 15%) = $2,613.75

This calculation may seem difficult, but really all I’m doing is adding that $18,000 back in as taxable income, which would fill up the rest of the 10% marginal bracket and spill over into the 15% marginal bracket.

  • $1,725 in the 10% bracket = $172.50
  • $16,275 in the 15% bracket = $2,441.25

To see what his effective savings on his taxes would be, all we have to do is take the amount invested and divide by the tax savings.

  • $2,613 / $18,000 = 14.52%

This is the important number to consider. If Steve can manage to pay less than this percentage in taxes in retirement, then he will come out ahead with all other things being even.

Roth 401k

If he chooses the Roth 401k and invests the full $18,000 each year, here is what his tax burden will look like using the formula from the marginal tax brackets above:

  • $36,000 – $10,400 (Standard deduction and personal exemption) = $25,600
  • $932.50 + 15% of the amount over $9,325
  • $932.50 + (($25,600 – $9,325) * 15%) = $3,373.75

This number should make sense because if we add Steve’s tax burden from the traditional 401k example to his tax savings, we should reach the same answer, which we do. To find his effective tax rate in this example, we divide his tax burden by his total income, just as before.

  • $3,373.75 / $36,000 = 9.37%

Calculations in Retirement

Finding what Steve’s effective tax rate is while working and what his tax savings is with a Traditional vs. a Roth account is well and good, but it means nothing without seeing the other side of the equation. In this case, that means looking at what his tax burden will be after FIRE in each situation.

Roth after Retirement

We’ll start with the Roth scenario since he won’t be paying any taxes at all, so there is basically no math to do. Steve will withdraw 4% of his portfolio to live on each year, which now equates to $18,000. Since he invested in the Roth 401k, his withdrawals are tax free for the rest of his life!

Traditional after Retirement

Now, obviously in the future tax brackets won’t be the same which I mentioned in both of the previous posts on this subject. Since we have no idea whether they will increase or decrease in the future for someone withdrawing the inflation adjusted equivalent of $18,000/year, we will assume that they stay the same. His $18,000 withdrawals will no longer truly be $18,000 because of inflation, but since we agreed to assume that raises and expenses will keep pace with inflation, effectively cancelling each other out, we can still use the same numbers. Keep in mind that if Steve is able to pay less than the 14.52% that he saved on his taxes by contributing to his traditional 401k while working, he comes out ahead by choosing this route. Let’s calculate what Steve’s tax burden would be when withdrawing money from his traditional 401k using the tax table from above.

  • $18,000 – $10,400 (Standard deduction and personal exemption) = $7,600
  • $7,600 * 10% (Marginal tax bracket) = $760

Since his taxable income remained the same both before and after retirement in this scenario, the tax burden is exactly the same. This also means that his effective tax rate will also be the exact same.

  • $760 / $18,000 = 4.22%

Conclusion

If Steve contributes to a Traditional 401k while working, he will save at his marginal rate, which for him, is partially in the 10% bracket and partially in the 15% bracket, leading to a blended rate of 14.52%. In retirement, due to the progressive tax code as well as the standard deduction and personal exemption, he will only be paying an effective tax rate of 4.22% on his traditional 401k withdrawals. That 10% difference will end up being well over $100,000 throughout a 30 year retirement when left to compound in low cost index funds.

As illustrated in this example, it is vital to remember to not compare your marginal tax rate before retirement to your marginal tax rate after retirement. The true comparison is marginal tax bracket before (or blended marginal rate if split between two brackets) to the effective tax rate after retirement. This gives a HUGE edge to Traditional accounts over Roth accounts, especially for those with low expenses meaning low withdrawal amounts in retirement. I hope that this helps to clear things up. Please feel free to ask questions below and go through the math yourself to make sure what I’m saying is correct.

Caveats 

This post would not be complete without me mentioning factors that would alter this scenario. If Steve has any income in retirement, that will change the effective rate at which his withdrawals will be taxed. Income sources could include: social security, pensions, income from part time jobs, and for those above the 15% tax bracket, qualified dividends. I don’t foresee a situation that any of these would completely cancel out the benefit of a Traditional account over a Roth account, but it would certainly reduce the overall benefit. It is important to run these calculations for your own individual situation to determine what is best for you.

 

 

 

 

Traditional vs. Roth IRA- A Real World Comparison

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendation in this area would be Will Butler.*

In my last post I talked about the difference between a Traditional and a Roth IRA and factors you should consider when deciding which account is best for you. That was my first 2,000+ word post, and since it was getting pretty long, I didn’t have room to add in an example comparing the two accounts. If you haven’t read that post yet, I encourage you to so that you have some context on the factors I’ll present in this post. I think using a real world scenario with two people in the exact same financial situation and the only difference being which account they choose should help to shed some additional light on the differences. There are so many different details in each individuals financial situations that will change things, so in order to avoid as much of that as possible, I’m going to do my best to look at an average situation for a single individual to avoid making this comparison more difficult than it needs to be. Keep in mind that just because this is a single person and your situation may be different, the majority of the considerations should still apply to your situation, but the numbers will be different.

The Subjects 

Bill and Jim are identical twins. Everything about their lives are exactly the same including: age, job, income, expenses, family situation (single with no kids), and retirement age. Let’s look at the specifics for them:

  • Living in Texas with no state income taxes
  • Standard deduction on taxes each year
  • Income: $52,000/year gross ($41,975/year net after federal taxes and FICA taxes)
  • Expenses: $38,975/year after taxes
  • Age: 28
  • Anticipated retirement age: 60

The employer that Bill and Jim work for does not offer a 401k, so they have to create their own individual retirement account (IRA). Bill decides that he wants to invest for his retirement in a Roth IRA, while Jim decides that he believes a Traditional IRA would be better. Bill invests $3,000/year (the difference between his income and expenses after taxes) into his Roth IRA. He knows that he will pay taxes on his contributions now but will get to withdrawal his contributions and earnings later without taxes. Since Bill and Jim are both in the 25% marginal federal income tax rate while working, Jim is able to contribute $4,000 to his traditional IRA due to not having to pay the 25% upfront tax on the $4,000 that resulted in Bill only having $3,000 to invest per year. Jim understands that he is getting a tax break on his contributions right now but that he will have to pay taxes on his contributions and earnings in retirement when he withdrawals the money.

They each contribute the same amount each year (Bill- $3,000 and Jim- $4,000) for 32 years until they reach age 60 and are ready to retire. For the sake of simplicity, lets assume that their income and expenses both remain the same throughout their working careers. Since their financial situations are identical besides the retirement accounts chosen, most of the inflation related increase would negate each other anyway and wouldn’t have a meaningful impact on the example. They each invest their funds inside their IRA’s in a mixture of stocks and bonds that results in a 8% return each year. Let’s check out how their accounts grow over the 32 year period.

IRA comparison- earnings

As you can see here, Jim ends up with a much larger ending balance, despite investment returns being the same, which is to be expected since he had the advantage of an additional $1,000/year invested due to his contributions being tax free. He also was able to experience compounding interest over the 32 year period on the additional $1,000/year. That leads to a total of $135,000 difference between the two at retirement.

A Closer Look at the Taxes

Now you’re probably thinking, of course Jim has a higher balance at retirement but that doesn’t matter because now he has to pay the piper and is taxed on all of his withdrawals from this point forward, while Bill gets to withdraw from his account tax free. You’re right, from this point on, Bill will be able to withdraw $38,975/year tax free to support his living expenses. So let’s look at exactly how much Jim will have to pay in taxes in order to be able to support his continuing $38,975/year of expenses. This is where marginal vs. effective tax rates come into play which I spoke about in the previous post. While working, when Jim contributed to his Traditional IRA while in the 25% marginal tax bracket, he saved that full 25% since each dollar he contributed was subtracted off the top of his total income which landed in the 25% bracket. This is not the case in retirement since any withdrawals have to fill up the lower tax brackets first before ever making it to the 25% bracket. Here are the current tax brackets with standard deduction and personal exemption to illustrate this point.

2017 taxes brackets.png

As you can see, Bill and Jim making $52,000/year puts them solidly in the 25% marginal tax bracket while working. When Jim subtracts $4,000 from his taxable income by contributing to his Traditional IRA while working, his taxable income goes from $52,000 to $48,000. Since that entire amount is in the 25% bracket, he saves exactly 25% in taxes on that $4,000.

Now we know the marginal tax rate they are in, but what is their effective federal tax rate while working? To figure this out, first we would take their gross income ($52,000) then subtract the standard deduction and personal exemption ($52,000 – $6,350 – $4,050 = $41,600). From there we use the info from the chart above to determine their total tax burden for the effective rate of the 25% tax bracket which is: $5,226.25 + (.25*($41,600-37,950)) = $6,138.75. Now that we know that the total tax burden for them while making $52,000 is $6,138.75, we can determine the effective federal tax rate by dividing the tax owed by the total income earned: $6138.75/$52,000 = 11.8% effective tax rate. This is a lot less than the marginal rate of 25% and why it’s so important to understand the difference.

Withdrawals in Retirement

As I stated earlier, Bill will be able to withdraw the exact amount he needs to live on during retirement which is $38,975 since he doesn’t have to worry about being taxed on his withdrawal. Jim’s situation is a little more complicated since he also needs $38,975 but he needs that amount after paying federal taxes which means he’ll actually have withdraw more than that each year to account for the tax bill. Exactly how much more you ask? It turns out he would need to withdraw $43,470 each year to have $38,975 after taxes. Let’s go through the calculation to see how I got this number using the total tax due calculations from above. Let’s take his gross income ($43,470) in this situation then subtract the standard deduction and personal exemption ($43,470 – $6,350 – $4,050 = $33,070). You’ll notice that since Jim only has to withdraw enough to cover his living expenses from this point forward instead of being taxed on his old $52,000/year income, this drops him down into the 15% effective tax rate after the standard deduction and personal exemption are accounted for. From there we use the info from the chart above to determine his total tax burden for the effective rate of the 15% tax bracket which is: $932.50 + (.15*($33,070-$9,325)) = $4,494.25. Now we take his gross income and subtract his federal taxes due: $43,470 – $4,494.25 = $38,975.75.

This reduces Jim’s effective tax rate in retirement to: $4,494.25/$43,470 = 10.3%! Jim is paying much less in taxes after retirement on his withdrawals than the 25% marginal tax savings he got in the beginning with his contributions. Let’s see how this plays out over the life of his retirement compared to his brother Bill assuming they continue to earn 8% on their investments throughout retirement while Bill withdraws $38,975/year to pay for his expenses and while Jim withdraws $43,470/year which after taxes equals $38,975 to pay for his expenses.

IRA comparision- retirement

Conclusion

As you can see, Bill only makes it 19 years into retirement before he runs out of money while Jim can continue to support his current expenses for 32 years! That’s a 13 year difference in retirement with the only difference being that Bill chose a Roth IRA and Jim chose a Traditional IRA. I hope that this illustrates not only how, for the majority of people, a Traditional IRA is likely the better option but also how big of a difference even small adjustments to your finances can make over a lifetime. Bill had no idea his retirement would be cut short by 13 years when he made that simple choice at 28 years of age.

There are a few things to keep in mind from this example.

  • This is not including social security benefits that they may get in the future. Social security benefits would increase Jim’s effective tax rate in retirement but no where near the 25% marginal tax rate he was able to defer when making the contributions to his Traditional IRA.
  • Jim and Bill would likely receive raises throughout their career pushing them into the upper range of the 25% tax bracket and likely even the 28% tax bracket by the end of their career which would further improve the case for the Traditional IRA but the calculations would be much more difficult accounts for promotions and raises.
  • Jim and Bill would both have increased expenses throughout their lifetime due to inflation but if the tax brackets also increase with inflation, which makes sense, then these two should balance each other out as far as effective tax rate on withdrawals in retirement is concerned.
  • Although Jim and Bill were single throughout their lives, the same math would apply for two similar families trying to decide between a Traditional and a Roth IRA just with different tax brackets, two standard deductions, and more personal exemptions.

What do you guys think? Does a real world example with the calculations make the differences between the accounts easier to see? When considering marginal versus effective tax rates and tax deferred compounding, what scenario can you think of where a Roth would actually come out ahead? The primary factor that most financial advisors site as the reason to choose a Roth over a Traditional is the possibility of increased taxes in the future, but is it worth it to bank on an increase and pass up such a powerful difference as illustrated here?

Traditional vs. Roth IRA- Which is Best for You as a Therapist?

*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendation in this area would be Will Butler.*

A couple of weeks ago I wrote my favorite post to date on the best student loan repayment option for those seeking financial independence. If you haven’t read that post yet and have student loans, I would encourage you to do so! The response I got from that post was interesting. Many people enjoyed how in depth I went with the calculations; some said that it was intriguing but wouldn’t  work for their personal situation; others said that they had been searching for a post like that for a long time and it was very helpful; and several people said I was a moron for ever thinking about keeping debt for 25 years despite the numbers making sense in my favor. To each their own, I guess. There was another common response that surprised me though, and that was, “Why would you choose a traditional IRA over a Roth IRA?” That was only a very tiny portion of that post yet it drew quite a bit of attention. After explaining my reasoning and hearing rebuttals, I realized that many people don’t understand the difference between the two at all and blindly choose based on what their financial guru of choice tells them to choose. The guru’s advice (cough, Dave Ramsey, cough) is often very general in order to fit a wide audience and very rarely the best advice for each individual’s situation.

Sometimes I have a hard time deciding what to write on this blog because my audience seems to be split pretty much 50/50. Half of the readers are physical therapists and student physical therapists that are reading because they are interested in travel therapy. The other half are die hard members of the financial independence/early retirement crowd. There is a small subset of readers that fall into both of these groups, but that is not very common. Since I want this post to appeal to all of my readers, I’m going to look at each group separately when determining what is best.

The Differences

Lets start with the basics in case there is some confusion on the difference between the two. It’s important to note that things change for people with higher incomes, but in this post I’ll just stick with how it works for the majority of the population.

  • Traditional IRA – Contributions go in pre-tax, meaning that you don’t pay taxes on the money when the contribution is made. The money then grows in the account (using whatever investments you choose) tax free. Your contributions and the growth made while in the account are taxed as ordinary income when withdrawn. Any money withdrawn before the age of 59.5 years of age is assessed an additional 10% penalty on top of your tax rate. A Traditional IRA is very similar to a 401k.
  • Roth IRA – Contributions are made with after-tax dollars, meaning that you pay taxes on the money before it ever gets put into the account. The money grows tax free (using whatever investments you choose) and is able to be withdrawn tax free. Contributions to the account can be withdrawn at any time without penalty, but any earnings made on your investments in the account cannot be withdrawn before age 59.5 without you being assessed a 10% penalty.
  • The current yearly maximum contribution is $5,500 ($6,500 if over age 50) regardless of the type of account chosen. Contributions can also be split between the two accounts if you wish as long as the total doesn’t exceed $5,500.

In summary, with a Roth IRA you pay taxes on the money before it goes into the account, but can withdraw contributions and earnings without taxes at retirement age. With a Traditional IRA, you don’t pay taxes on the money when it is put into the accoun,t but you do pay taxes on the contributions and earnings when you withdraw it at retirement age.

How to Decide

The easiest way to determine the right account for you is to look at your marginal tax rate now and compare that to what you believe your marginal tax rate will be in the future. Since none of us (unless you believe in psychics) can predict what the tax brackets will look like when we retire, there is some educated guessing that goes into this. A very good indicator of whether you taxes will be higher now or later is to look at your current savings rate.

If you’re making $60,000/year, yet spending only $30,000, which is the case for many in the FIRE (Financially Independent Retired Early) crowd is doing, it is extremely likely that you will have a lower tax rate after retirement since you will only need to withdraw $30,000/year (inflation adjusted of course) to live on in retirement. Having a lower tax bracket after retirement compared to your current tax bracket is the ideal reason for choosing a Traditional IRA over a Roth IRA.

If you’re making $60,000/year and spending $55,000/year currently and you expect that you will be spending even more after retirement due to wanting to live on the beach and travel the world, then a Traditional IRA wouldn’t make sense for you. You will likely be in a higher tax bracket after retirement and would be better off paying taxes now and withdrawing the money tax free later.

Which is Best for You?

For the physical therapist readers, you could go either way here depending on your spending habits. If you save a decent proportion of your income (15-25%+) currently and plan to have a similar costing lifestyle once you reach retirement age, then a traditional IRA would probably be best for you since your tax rate will likely be lower in retirement than it is now. If you are mostly living paycheck to paycheck and aren’t able to save very much and plan for your retirement expenses to be similar to what they are now, then putting as much as possible into a Roth IRA is probably going to be better for you. If you’re somewhere in between these two scenarios, it might be a good idea to split your contributions 50/50 between the two in order to hedge your bets.

For the FIRE readers, it is very hard to argue against fully funding a Traditional IRA since, in order to achieve FIRE, your savings rate is obviously pretty high meaning that your tax rate will likely be lower after retirement than it is now. There is also a very good chance that by keeping your expenses low in retirement, you’ll be able to access the money in your Traditional IRA early without penalty and at a low tax rate. I don’t want to try to reinvent the wheel when the Mad Fientist has already done such an awesome job at explaining how this is possible in his article. This is personally the route that I am choosing to take with my financial plan.

Common Arguments on the Topic

It seems that many financial advisers as well as individuals knowledgeable on the topic have their own opinion on what is best. Here are some things that I’ve heard mentioned when discussing which account is best.

  • “Do you trust the government to not increase taxes over the next 40 years? No way would I gamble with what future tax brackets and rates might be, it’s better to pay the taxes now with a Roth IRA and not have to worry about future tax hikes.”
    • On the surface this seems like a valid argument. The future is definitely uncertain. It seems like taxes have increased over the years, right? Actually that incorrect. The reason it seems like taxes have increased is because of inflation. In reality, the effective tax rate for the median household income (~$56,000/year) has decreased over the past 70 years in inflation adjusted dollars. Anything is possible, but if the past 70 years are any indicator, we shouldn’t count on taxes increasing significantly in the future at the median household income. (Here’s a cool site a found where you can enter your current income and see what your tax rate would have been throughout history).
  • “Since Roth IRA contributions can be withdrawn at any time without penalty, a Roth is best since you can use your contributions in case of emergency.”
    • This is an absurd argument in my opinion. Instead of taking money out of a retirement account where it can grow tax free, you should have a big enough emergency fund or a plan to cover unexpected expenses so that you don’t have to touch your retirement savings regardless of the type of accounts it’s in.
  • “Reducing tax liability today using a Traditional IRA saves you money at your marginal tax rate today, since it’s being subtracted off the top of your current income, while being taxed at your effective tax rate later since the money withdrawn from the account will first be used to fill up the lower tax brackets.”
    • This is true and a solid point in favor of a traditional IRA in my opinion. Let’s look at an example to illustrate this using a single individual with a gross income of $65,000/year (a fairly common starting PT wage). At $65,000/year you would be firmly in the 25% tax bracket. That means that by contributing to a traditional IRA now, you would reduce your federal tax liability by 25% of the amount you contribute since it’s taken off the top. Now fast forward to retirement age and say you still want to live off of $65,000/year (in inflation adjusted dollars). Since we can’t predict the future, let’s assume the tax brackets are the same in the future as they are now. Now when you withdraw that $65,000 from your Traditional IRA (still assuming being single to not complicate things), the first $10,400 of that amount would be tax free due to the $6,350 standard deduction and $4,050 personal exemption. The next $9,325 would be taxed at 10% to fully fill that bracket. The next $28,625 would be taxed at 15% to fill that bracket. And only the last $16,650 would be taxed at the 25% marginal rate. This leads to an effective tax rate of only 14.15%. You would reduce your current tax liability at an effective 25% tax rate while paying only a 14.15% effective tax rate on the same amount at retirement. If this seems like gibberish to you, don’t worry, it took me a long time to realize the difference between marginal and effective tax rates as well. Check out this article that should hopefully give you a little better understanding of the difference between the two. **Keep in mind that this scenario is assuming that there is no other earned income in retirement which may or may not be the case for you depending on your situation. Having earned income could change things by a little or by a lot depending on how much it is.**
  • “You expect to make more money throughout your career, don’t you? Then a Roth IRA makes sense because it’s taxed now.”
    • When I was in PT school I went to the Virginia Student Conclave one year, and this is an almost word for word quote from a financial advisor speaking there on Roth vs. Traditional IRA. This seemed to make sense to me and I wrote in the notes I was taking, “Always use a Roth.” The problem is that whether or not your income increases during your career doesn’t matter, what matters is what your income will be in retirement which is directly related to your expenses. It would be foolish to start making IRA withdrawals while you’re still working and in a high tax bracket later in your career, so that is a foolish argument.

The last tid bit I want to add on IRAs (regardless of which type you choose), is that it is important to remember to contribute to your 401k up to the employer match before contributing to either a Traditional IRA or a Roth IRA. The employer match is free money and is always going to be your best return on investment.

Summary

Deciding between a Roth IRA and a Traditional IRA is not as simple as choosing a Roth IRA because Dave Ramsey says it’s best. I believe that for the majority of people, a Traditional IRA is the superior option unless you expect huge lifestyle inflation after retirement. If your tax rate is higher now than it will be in retirement, a Traditional IRA is right for you. If your tax rate is lower now than it will be in retirement, a Roth IRA is right for you. You should sit down and think critically about your own situation and what your life looks like now and what it will likely look like after retirement, otherwise you’re shooting blindly. And remember, always take advantage of the employer match in your 401k if available.

Were you aware of the difference between these two accounts? Which account do you currently contribute to and why? Did you think about your current and future tax bracket when making your decision or did you just take the advice of someone else who told you it was the right thing to do? Thanks for reading!

 

Updating Financial Assumptions and Goals

When I first started this blog and began writing about my progress to financial independence (FI), I put a lot of thought into my goal net worth amount. That goal amount combined with my current savings rate, monthly expenses, and estimated investment returns are what I’ve been using to track my progress to FI each month. The problem is that over the past 14 months, since I started documenting my progress, my ideas about what financial independence is and what I plan to do when I get there have changed. Initially, I took my current yearly expenses, added a 40% buffer due to uncertainty in the future (likely kids at some point), and then multiplied that amount by 25 (based on the 4% rule) to figure out the amount that would be my target.

After reevaluating, I believe the 40% buffer is very conservative and probably not realistic. My initial reasoning was that my yearly expenses will inevitably increase once I finish traveling and settle into more permanent housing and will also increase once I have children. While I still believe that my expenses will increase, I have decided that a 25% buffer is probably more realistic especially when considering the fact that I will likely still have some sort of income after financial independence, although I’m still not sure what I plan to do exactly. In addition, I plan to spend at least a portion of each year living outside of the United States (at least in the beginning) in lower cost of living areas such as southeast Asia. Traveling and living abroad should be a great way to broaden my worldview while simultaneously decreasing my expenses.

I have now adjusted my spreadsheet to reflect the decrease in my spending cushion from 40% down to 25% and the result is pretty cool. All of a sudden my FI date is about 8 months closer, and I’m almost exactly halfway there after only working for two years. Seeing this result made me reconsider my goal. When I started this blog my plan was to reach financial independence with only a five year working career which would have been right around my 32nd birthday. After steadily saving more and more each month over the past year, the estimated date got closer, and now after this adjustment and a change to my estimated monthly savings last month, I have a new target in mind.

My new goal is to reach financial independence at the age of 30 after only a 4 year full time working career. I define financial independence as my current yearly expenses plus a 25% buffer being 4% or less of my total net worth. Although this goal may seem lofty, I am 100% certain that I can achieve it with higher paying travel jobs, working as much overtime as possible, working PRN jobs when available, and continuing to hustle with bank account and credit card sign up bonuses. I also plan to begin seeking out opportunities to make extra money by writing posts for other blogs and continue to earn referral bonuses for matching other travel therapists with a couple of my favorite and best recruiters.

It always feels great to put my goals out there for you guys to hold me accountable and follow along. The blog has grown a lot lately, and I sincerely appreciate everyone that reads my posts. I want to encourage everyone reading this to create your own financial goals and share them publicly for critique and to create accountability. I welcome any comments or questions in the comments section below! What are your goals for the next two years??

The Importance of Asset Allocation

Disclaimer: I am not a licensed financial advisor, and the information in this article is not meant to be individualized financial advice. Everyone’s situation is different, so if you are unsure about what to do with your funds, please seek an advisor that can consider your own individual case and make recommendations to you.
When I first began reading about asset allocation for my investment accounts, I felt like I had just opened up Pandora’s Box. You can find endless articles and blog posts on the subject, but I feel that many of these over-complicate the issue.  The truth is, asset allocation can be as simple or as hard as you choose to make it. Mutual funds that are focused on different fund classes are an option, but probably not the best one. The reason for this is the additional fees associated with mutual funds that inevitably eat into your earnings. For this reason, I choose to diversify my portfolio among a variety of low cost index funds. For more on index funds, read this post where I give some background.
Before I get too ahead of myself, let’s talk about why asset allocation is important. Asset allocation allows you to spread your risk out over multiple asset classes in order to decrease the possibility of catastrophic loss in any one class. The major asset classes include: equities (stocks), fixed income (bonds), and cash equivalents. I would also add real estate (REITs) and commodities (Gold, oil, silver, etc.) as separate classes even though they aren’t considered “traditional.” Within each of these large classes it is further broken down into many subsets, then many of those subsets are broken down into further subsets. This could get confusing and complicated if you are trying to micromanage every portion of your portfolio. But what can happen with improper asset allocation? In short, you can lose a lot of money, but this is best illustrated with examples.
First let’s look at an extreme example of what can happen with little or no asset allocation to drive home the importance of diversification. Say you decide that you really like Apple products and choose to invest all of your retirement savings into Apple stock. Now jump forward to the year before you plan to retire. A new cell phone is made that completely blows the iPhone out of the water. Since most of Apple’s profits are from their phones, their stock price plummets, they are no longer profitable, and they go out of business. In this example, you lose most, if not all, of your retirement funds. This is not the most likely scenario, but you never know what the future holds. Where did you go wrong here? You put all of your proverbial eggs in one basket. You were not at all diversified, and that led to significant loss.
Now let’s look at an example that is a little less extreme but that involves only investing in one asset class. In this scenario, you decide to use a low cost S&P 500 index fund, but you have very unfortunate timing. It’s January 2008 and you are very excited that you will be retiring in a year. Between January 2008 and January 2009, the US stock market dropped about 37%, which means that you only have 63% of your initial investments available for retirement when the day comes. Do you think this drop would drastically alter your retirement plans? Most likely. These investment mistakes can be financially devastating and should be avoided at all costs. In the first example, you were very risky with your asset allocation, only investing in one fund (Apple) in one subset of one asset class (US equities). In the second example, you had a little less risk because you were more diversified over the 500 biggest equities in the US (S&P 500 index fund), but still this is only one subset of one asset class.
No matter how well you diversify, you will always have some risk when investing and could always lose money, but proper asset allocation makes that less likely. Also remember that timing can play a huge role in return, so no matter your allocation, investing should be a long term plan.
Individual asset allocation should be a well thought out process with your goals in mind. Based on previous returns and volatility, it is possible to estimate what your returns will be; but, usually, with higher returns comes more risk. It is conventional wisdom that the more money you put into bonds and cash equivalents, the safer and less volatile your portfolio will be. This should be a strong consideration for you, because if you have so much risk in your portfolio that you are losing sleep due to worrying about how the market will perform, you need to make some adjustment. A good financial advisor can be a valuable asset in helping you to make your decisions, but there are a lot of online resources that can help you get started for free. I have recommended this book before, but I feel that it is very fitting in this situation as well: The Bogleheads’ Guide to Investing helped me significantly when I was starting out.  Also lazy index fund portfolios is a very good resource if you choose to go that route.
Initially I decided that I was going to allocate my funds using the three fund portfolio because it was so simple, but later, after much reading and learning, decided that I would like to be exposed to more asset classes including REITs and commodities. My current allocation includes: Domestic stocks (value and growth), international stocks, emerging markets, bonds, precious metals, REITs, and energy. This is what I have chosen based on my goals, but this allocation may not be right for you.
After you choose your allocation and invest your money accordingly, it is inevitable that some classes will grow more quickly than others. This means that “rebalancing” will need to occur at regular intervals to keep you on track with your target asset allocation. Basically this means moving your money around to achieve your target percentages once again. Usually once a year is sufficient for this, but some choose to rebalance more often.
How do you plan to allocate your assets? Are you comfortable with a lot of risk in your portfolio or are you more conservative? I hope that this information will help to get you started if you haven’t already. Thanks for reading!

Options for Where to Invest Money in Retirement Accounts

Disclaimer: I am not a licensed financial advisor and the information in this article is not meant to be individualized financial advice. Everyone’s situation is different, so if you are unsure about what to do with your funds, please seek an advisor that can consider your own individual case and make recommendations to you.
Once you have opened your IRA or brokerage account and have begun contributing, you may run into a problem. Where should you invest the funds in the account? Is it worthwhile to try to choose stocks on your own to invest in? Are mutual funds the best option for safety? What about index funds? This can all be very complicated as there is a nearly unlimited number of options for your investment accounts. After reading several books on the subject, as well as blog posts and podcasts, I determined how I will invest the majority of my funds. Before I talk about what I chose, let’s discuss some of the options. There may be additional options for very high net worth individuals, but I will keep this more geared to the new investors which will mean that you likely don’t have millions of dollars to invest.
  • Choosing your own individual stock funds: This is by far the most risky option and not one that I would recommend for 99% of people. There are people who choose stocks for a living and still lose money in this realm. The possibility of someone with no investment knowledge and limited amounts of time to study individual stocks succeeding here is very rare. Please do not buy stocks of a company just because you like the company but have no knowledge about the business aspects or finances of that company, this is just asking for trouble.
  • Picking a mutual fund and letting the fund manager choose where to put your money: A mutual fund is a collection of individual funds. These could be stocks, bonds or other assets. Because of this, mutual funds are less risky because your money is more diversified across multiple funds instead of just one fund. At any given time an individual fund could drop significantly in value due to some unforeseen circumstance, but it is much more unlikely that this will happen to several funds at the same time. This is a much better option that choosing individual funds for the majority of people. So what about the cons of mutual funds? Mutual funds charge fees for managing your money and this fee is charged no matter whether your money is increasing or decreasing in the market. In addition, although some mutual fund managers are able to do a good job of picking funds and “beating the market” in an individual year, the amount that are able to outperform the market in the long term is very low.
  • Investing in index funds: An index fund is a fund that literally tracks an index. An index is made up of many, many individual stocks. You’ve probably heard of the S&P 500- this is an index made up of the 500 biggest stocks on the New York stock exchange. If the majority of the individual stocks contained in the index increase in value, then the index also increases. It is possible to put your money into an S&P 500 index fund or into the index fund of any number of other indices. There are also index funds for different sectors of the market such as energy, precious metals, international funds, etc. Since an index fund’s holdings are based on the index it tracks, it is considered a “passive” investment. That means that there is no manager who makes decisions regarding the fund, but instead the holdings adjust based on the holding contained in the index that it tracks. This means that you can achieve the same amount of diversification, or more, than you can with an actively managed fund without the extra fees associated with having someone “actively” make adjustments to the holdings.
  • Exchange traded funds (ETF): These are very similar to index funds and for most part time investors, it won’t make a very big difference if you chose an index fund or an ETF of a certain index. To learn more about ETFs vs. Index funds, here is a very good article.
It is important to take these options into account and fully understand what they mean before making a decision on the matter. Due to the fact that mutual funds charge fees and are only occasionally able to outperform the market, I choose to follow a more “passive” strategy with a portfolio of index funds. This makes the most sense for me because I do not have the knowledge or time to allocate to choosing individual stocks. If the indices in which my money is invested go up, then my money will increase; but the opposite is true as well.
It is also important to come up with an “asset allocation” and consider it before making choices. Your asset allocation is a very individualized decision and where a good financial advisor can really be of value. I will write more about asset allocation in a later post, but this is basically where you decide how much of your money you would like to have in stocks (domestic or international), bonds (domestic or international), and cash equivalents (cash, gold, silver, etc.).
There are two books that I would highly recommend on the topic of investing and those are:
I have read several others, but these were the two that taught me the most about the stock market and investing. They both strongly support index fund investing as well, which I believe is the best option for the majority of people reading this post.
Where do you put your money? Do you believe that index funds are the best option? I would love to hear other opinions on the subject. Thank you for reading!

Don’t Repeat My Investing Mistake

You’ve decided that you should save a portion of your paycheck, hopefully 10-15% or more, and you are confident that this is the right thing to do. But now that you have saved the money, where do you put it? Do you let the money sit in a checking account earning no interest? Do you put it in a savings account… earning, basically, no interest? Do you invest it in the stock market where returns can be all over the place? Mutual funds are a thing that you have heard of, are they the holy grail for decent returns with less risk? I was in this same position when I as in my late teens. I had $12,000 that I had saved from working full time during the day, delivering furniture, while going to community college at night over the course of two years. I made a huge mistake with my money and lost half of it in 9 months. I would like to help you not make the same mistake.
First I’ll explain a little bit about what happened with my money. The year was 2008 and I had been working hard to save all that I could in preparation for transferring to a university after completing my associates degree.  It was my goal to save enough while working full time during community college that I would be able to pay for as much of my living expenses as possible from savings after I transferred. I assumed that a university would be much harder than community college and wanted to not have to work once I began so that I could focus on getting the best grades that I could. All of the adults in my life at the time told me that a mutual fund was the way to go. This was the best way to get decent returns on my money without much risk because the capital is diversified across multiple individual stocks. The stock market was a great choice, they assured me, because it had been going up steadily for several years. Everyone was making money in the stock market and it would continue for a long time (warning sign). I was intimidated by the whole process but was eager to have my money working for me, so I agreed that I would meet with an advisor and put my money in a mutual fund.
The first couple of months that my money was invested, it was steadily increasing, and I was kicking myself for having let the money that I had accumulated sit in a checking account for so long, basically doing nothing. I even began to add to the amount in $1,000 increments as I was able. Then, all of a sudden, I logged into my account one day after about a week of not checking it, and to my horror, the number was down about $1,500. I panicked and called my mom. Who else do you turn to in a time like that? She assured me that this was normal and that I should leave the money alone and it would eventually rebound. This eased my mind, but I was still very concerned. Over the next several months, the account did not rebound, it got much worse. After about nine months, I decided enough was enough. I called the advisor and demanded that the mutual fund be cashed in. Since the advisor that I chose didn’t really care about my well-being, he didn’t try to deter me and help me to make a more rational decision. I ended up with about $6,500 of the original $12,000. My two biggest mistakes that I made in this situation were that I was not selective about the advisor that I chose and also that I had no idea about the inner workings of mutual funds or the stock market in general. At the time of this writing, had I left the money alone and never taken it out of the mutual fund, I would have over $20,000. The stock market did rebound and it rebounded to a huge degree, but I was in it for the short term and not looking at the bigger picture. After losing so much money, I was determined to never invest in the stock market again. Luckily, since then I have had a lot of time to learn about finance and investing, and I am able to recognize the mistakes that I made.
Any investments made into the stock market have to be focused on the long term. No one can accurately predict the daily, weekly, or monthly fluctuations of the market, but we know for sure that historically, over time, the market has increased at an average rate of 8-10% a year. Any money that you invest should be money that you will not need to touch for at least 5 years, but more likely closer to 10 or more years. For most people this means retirement savings or college savings for their children. There are other places that you can put money that you will need in the shorter term (

The Simple Way to Determine Your Retirement Date

Early retirement and financial independence sound pretty amazing, right? Stop working full time and pursue other interests, spend more time with family, travel to new places, or just continue working while having the peace of mind to know that you can stop whenever you want. What’s not to like? At this point, you may be wondering how long it would take you to achieve this kind of freedom. Before you can set a goal date, it is important to know how much you will need to officially announce that you are financially independent. The answer to that question may seem complex to figure out, but it’s really pretty simple. This is due to what is known as the “four percent rule.” Basically the four percent rule states that if you have your money in a well diversified portfolio going into “retirement,” you will be able to withdraw four percent of your beginning investment each year without ever running out of money. The calculations that were used to determine this rule are based on historic stock and bond returns. For example, you will need $1,000,000 invested in a well diversified portfolio in order to withdraw $40,000 per year for the rest of your life without ending up in the poor house.

This is somewhat of a worst-case scenario though. Considering the average market return of 7-9% per year over long periods of time, four percent may seem pretty low to you. You’re right, it is low. It is much more likely that you could withdraw a significant amount more than four percent each year and still be fine, but better safe than sorry when your financial future is at stake. I don’t know about you, but I would much rather overestimate and have too much money at the end of my life than to underestimate and end up eating cat food for my last few years on earth.

Figuring out how much money you will need in order to live off of four percent can lead to difficult calculations for some. But, never fear, we have the power of elementary school math to help us out. Working backwards, you can determine how much your current yearly expenses are, and then multiply that number by 25. As with the previous example, if you add up your expenses and determine that you will need $40,000 per year to maintain the lifestyle that you wish to have, $40,000 x 25 = you guessed it, one million dollars (please imagine me saying this in a Dr. Evil voice).

In order to determine what your yearly expenses will be in retirement, you will need to make some educated guesses. Will you be spending less money on gas when you don’t have to drive to work each day, or will your gas bill increase because you plan on driving around the country several times? Will you be living in the same house for the rest of your life, or is it likely that you will upgrade or downgrade? Will your health insurance costs increase after you retire? Will you  be spending your extra time cooking more meals at home or will you go out to dinner more often? Only you are able to answer these questions for yourself, but I would suggest being conservative on the estimates.

There has been some criticism of the four percent rule for early retirees because it is usually based on a “normal” length retirement, not fifty or more years that are possible with early retirement. For my situation, I do not believe that this will be a concern. My reasoning for this is that I plan to continue to “work” on something for the rest of my life. It is highly likely that I will be able to monetize one or more of the hobbies that I pursue in the future. Even if this turns out to not be the case, I will have no problem working part time at any number of jobs to earn a little additional money if needed. It would take only a very minimal amount of income to supplement the returns from my investment portfolio, if any at all. In addition, I enjoy earning cashback and achieving now sign up bonuses on credit cards. It is very unlikely that these things will change in the future, and this will lead to some additional income (or at least reduced travel expenses) as well. I will feel completely comfortable declaring myself financially independent when I reach my target number based on the four percent rule.

So now that you have the actual amount that you will need in order to live off of (i.e. the $1,000,000.00 from the previous example), you can use a compound interest calculator to determine when you will be able to get to that number. The calculator is very easy to use and lets you choose all of the factors on which you choose to base your calculations. I use a conservative yearly savings amount as well as a 5% expected rate of return just to be safe.

Based on all of my projections, I am well on my way to being financially independent before my 33rd birthday. This would make my “working career” only about six years total, but again, I will likely continue to do some kind of “work” for the rest of my life. The difference being that it will just be exactly what I choose to do at that time. Do you have an estimate of when you will be financially independent? Do you believe that the four percent rule is sufficient or are you planning to have a bigger safety net? Do you enjoy living on the edge and/or love the taste of cat food, and choose to retire earlier? I’d love to hear other thoughts on the topic. Thanks for reading!

What Financial Independence Means to Me

About a year ago, I became fascinated with the idea of early retirement. There is a small group of people that I discovered through blogs and podcasts from whom I learned a great deal. Most people in the mainstream have never even considered early retirement an option and neither had I. It seems the norm to spend almost all of what you make while only saving a very small amount for retirement, or financial independence, as I prefer to call it and will refer to it from this point forward. The reason that financial independence is a more fitting term is because I don’t plan to “retire” once I reach financial independence, but I do plan to be financially able to pursue whatever I may choose. My personal financial plan leads me to this ultimate goal in approximately 5 years. It could be more, it could be less depending on what life has in store, but overall I am confident that I am heading in the right direction.

I believe truly learning yourself and what makes you happy is a never ending process. I am still very early in this process, but it is already readily evident to me that what I am interested in today is likely not what I will be interested in ten years from now. This may not be the case for everyone, but for me I know this to be true. Although I love physical therapy at this point in my life, I want the freedom to go back to school or change careers in the future if that’s what I choose to do, without the fear of not being able to pay my bills. Also, I plan to have kids within the next five to ten years, and I want to be able to spend as much time as I choose with them. Even if you love what you do and you can’t imagine not doing that thing for the rest of your life, wouldn’t the freedom to take off when you needed to for life circumstances (family vacations, illness or death in the family, or whatever else life may have in store) be invaluable? So you’re thinking, yeah that sounds great, of course everyone wants that freedom, but how is that possible?

Financial independence comes down to one factor, and that is living below your means. It will never be possible to be financially independent before retirement age if you only save a small amount of your income. You could be the world’s best investor, but it is difficult to invest without capital. There are only two ways to live below your means: make more or spend less. For me, this was a big factor, but not the only factor, in choosing travel physical therapy. I am able to make more money than I would if I were to take a full time job somewhere. In addition to earning more, I also focus on spending less. Whitney and I split all of our expenses; we both have budgets and we do our best to stick to them. We strive to save as much of our income as possible.

Trying to save as much as possible while also still enjoying life can be a delicate balancing act, but we do a very good job of balancing each other out. I’m all for saving as much as possible, but that doesn’t mean I’m willing to sacrifice my happiness in the present in exchange for gaining early financial independence. I have always been a natural saver, but Whitney does a good job of keeping me in check and keeping me from being too frugal. We are lucky enough to be able to save a substantial amount without having to sacrifice much, if anything, that we want. We have had a number of exciting experiences thus far in our first year out of school, while still saving at least 75% of our paychecks each month. I understand that this isn’t feasible for everyone, but by choosing the paths that we did, this is possible for us. Regardless of your specific circumstances, there are definitely ways for everyone to take a look at your budget and begin saving more than you spend, while still having great experiences and enjoying the present.

One example of how we made sacrifices to be in our present situation is that we saved for 6 months right out of school in order to pay cash for both our camper and our truck, instead of going with costly financing. This meant that we had to sacrifice and find alternative housing for our first two contracts (living in an over the garage apartment at someone’s house we found on Craigslist), rather than jumping right into our plan of living on our own in the camper.  This decision definitely paid off, and now we are living out our dream plan.

To some, living in a camper itself may seem like quite a sacrifice, but we don’t see it that way at all. The camper allows us to avoid having to pack and move every time we finish a contract. Which is not only a hassle, but also a waste of time, which ultimately means a waste of money. The old saying “time is money” is true throughout life, but especially so when there is no such thing as paid time off. In addition, the camper gives us some consistency when moving. We may have to adjust to a new geographical location, new people, and a new work environment, but no matter where we go, our living area will be the same.

Other ways that we “sacrifice” to save money include eating in and cooking most nights of the week, packing lunch everyday, and making coffee at home. We still enjoy eating out once or twice per week, and if there’s some special treat we really want, yeah we can go ahead and buy it. It’s really not that big of a sacrifice if you just make it part of your lifestyle. I like to think of every dollar I spend on something in terms of how long I have to work to pay for that thing. For example, if you buy coffee every day before work at an average of $3 per coffee, times 5 days per week, times 52 weeks a year, over a 30 year career, you could have saved $23,400 in cash. If that same amount was being invested (i.e. in your 401k or IRA) at an average return of 7% per year (reasonable based on previous market returns) you would end up with just below $80,000 saved over a 30 year career. Based on the average individual income of approximately $30,000 per year gross income, that would mean an approximate additional three years of work to fund this daily habit after taking income taxes into account. Everyone has their own priorities, but to me this just doesn’t seem reasonable. You can take this same example and apply it to bigger purchases too, such as eating out daily, or even choosing a  more expensive car or house.

The point of this is that life is about perspective. What seems like a sacrifice to one individual is not at all to another. Make a list of the things in your life that are truly important to you, and then make a list of the top places in which you allocate your money. Do the things at the top of the lists match up? If not then that is an ideal place for reflection. Now look at the bottom of the list of things that are important to you. Could you allocate fewer resources to those “unimportant” things in order to reach “freedom” sooner? Again, time is money, and the more money you spend today the further you push financial freedom into your future and take the focus away from the things that are truly important to you. Is a new car and house what truly makes you happy, or is it a status symbol? Do you use all of the space in your house or apartment, or could you get a smaller space that is still accommodating while paying less? Is coffee at Starbucks and eating lunch out every day worth an extra few years working at the end of your career when you are ready to pursue other interests or spend more time with family?

Every day is a gift and there is always the possibility that there will be no tomorrow. But, if you are able to live a full life today and allocate your resources to the things that truly matter to you, while also saving a substantial amount for the future, then why not? To me this seems like common sense, but I know that it isn’t because I have met many people that can’t understand why I wouldn’t just buy things because I can afford them.

Financial independence to me means freedom. Freedom to do whatever I want, whenever I want. I may go back to school at that time; I may begin a new career; I may travel the world (frugally of course); or, I may continue working as a physical therapist, whether full-time, part-time, or PRN. But the point is, I will have that choice because of financial independence. I won’t be locked in to a 40+ hour work week. Whatever I choose to do when I reach financial independence, it will undoubtedly include: family, reading, learning, developing new skills, and making the world a better place to the best of my ability. This is a top priority in my life and I imagine that it will be for the foreseeable future. Thanks for reading. What are your thoughts on the subject?

Disclaimer: This is not meant to be specific financial advice, just illustration of the concepts that I choose to apply to my own life.