Imagine that you arrive for an appointment to see a new doctor. You have been experiencing chronic neck pain and want to ensure the symptom is not due to a major health condition. You enter the office lobby and walk up to the desk to check in. Before you even say who you are, the receptionist hands you a bottle of pills and tells you that you should have heart surgery next week. What?!? The doctor did not check your vitals, discuss your symptoms, run medical tests, or even see you for that matter!
Unfortunately, this is the same type of ‘treatment’ people receive in regard to financial wellness. Generic one-size-fits-all advice can be seen and heard across multiple mediums, including books, blogs, radio shows, courses, social media threads, YouTube videos, and family gatherings. Not all of this advice is intrinsically ‘bad’ or meant to harm you, but there is a disconnect between what’s best for others and what’s best for you. I believe it is not possible to give advice in the best interest of others without understanding his or her personal financial ecosystem. This article reveals some of the common dogmatic (“the only way”) financial responses, but also some alternative approaches to challenge assumptions and keep finance personal.
The topic of paying off debt vs. investing is hotly debated, with one-size-fits-all answers that are focused solely on the math or only on the mind. Debt is often divided into ‘good’ and ‘bad’ categories. Good debt means that the benefit of the asset/leverage lasts longer than the indebtedness, the debt is usually secured (backed by an asset), the asset is likely to appreciate or increase net worth, and the interest rate is low (<5%). Bad debt means that the indebtedness lasts longer than the benefit of the asset, the debt is usually unsecured, the asset is likely to depreciate, and the interest rate is high (>5%).
I prefer to think about money in terms of time; good debt terms usually offer interest rates that seem competitive against expected stock market returns, but this optimism about future possibilities is influenced by confirmation bias – the tendency to seek information that confirms an existing belief. Before you make any decisions based on market data, keep in mind that past market returns are not indicative of future investment performance. The only guaranteed return is that of your debt lender when you pay interest. Also, keep in mind that paying off debt is an emotional decision; for many people, the flexibility and peace of mind that being debt-free provides is more meaningful than potential market upside.
Advice for how much to save for retirement widely varies. The ’50/30/20′ or ‘10% to 15% of your gross income’ rules of thumb are usually suggested and interpreted without understanding key assumptions – notably the investment time horizon, historical investment returns, and expected retirement income needs. I create my retirement savings strategy using dollar amounts ($) rather than savings rates (%), because household income will change over time. For example, if I discover that I should be saving $22,000 per year to reach my financial independence goal by a certain age, I can then determine which investments vehicles and their respective contribution limits will most appropriately align with my savings goal. Continuing with the example, contributing $3,600 to an individual HSA, $6,000 to an IRA, $7,400 to an employer retirement account, and $5,000 to a taxable brokerage account could be aligned with my personal objectives. Making these decisions solely based on percentages can be more complicated, especially if your income is variable. Even if our household income changes, it does not automatically change our annual savings amount.
Here is a retirement savings calculator that allows you to view your savings goal as both dollar amounts and savings rates. Stress-test your investment return and inflation assumptions, and use this tool as a starting point.
Investing plays a significant role along the path to financial independence, but there are other prudent steps to implement before putting money to work. These steps include assessing your current situation, mitigating financial risks, and determining your asset allocation and location, tax profile, investment time horizon, and personal risk tolerance. Institutional and retail investors can be eager to advise others on what to buy and sell, but be careful not to act upon financial advice from someone who does not fully understand your financial ecosystem and personal objectives. Also, be wary if the source receives compensation based on your purchase of investment or insurance products.
Note: It is also common to hear that you should align your bond allocation with your age, but this advice does not account for your portfolio’s objectives and ability to meet your retirement income needs. There are also numerous bond categories, which can provide varying degrees of income, capital appreciation, and/or stability.
The decision to contribute to Traditional (pre-tax) and/or Roth (after-tax) retirement accounts should consider many variables, not limited to your tax rates today vs. your assumed tax rates in retirement. Both options have potential advantages and disadvantages, across topics such as early retirement (before age 59 1/2), health insurance subsidies, state income tax, cash flow flexibility, Social Security, Medicare premiums, required minimum distributions (RMDs), inheritance, charitable giving, filing status, deductibility, and distribution rules. This topic should be reviewed annually, and there are educational resources available to help you make well-informed decisions in alignment with your personal objectives.
The advice to transfer (roll over) employer retirement plan assets like 401(k)s to an IRA after terminating employment is common, but there are unintended consequences to consider before making this irrevocable move. The plan administration and investment fees should be reviewed, as these could be more or less favorable than your IRA options. Plan participants may also receive less expensive institutional share classes or stable value funds unavailable to retail investors.
If separating from service in or after the year you turn age 55, you may be able to distribute money from your 401(k) without a 10% additional tax, while the IRA rules require age 59 1/2 or another qualified distribution exception. Similarly, you may have your retirement assets invested in a 457(b) plan with more favorable distribution rules than an IRA.
If a participant holds employer securities in a qualified plan, there could be a tax-efficient opportunity to separate the stock from the rest of the lump-sum transfer, paying ordinary income tax on the stock basis but allowing the ‘net unrealized appreciation‘ and future growth to receive favorable tax treatment within a taxable brokerage account. It can be helpful to consult a financial professional before making these moves. Be mindful when consulting an advisor who may have a conflicting interest to personally manage your IRA for compensation, vs. leaving the money in your employer retirement plan.
These financial contracts are commonly misused and misunderstood, with a wide range of complicated structures, obscure illustrations, and high fees. It is often said that annuities are sold more than bought, but that does not mean all annuities are inherently bad. They can provide a steady income stream, usually to meet basic lifestyle needs or supplement other expenses while protecting against the risk of outliving retirement assets. Protection from market downside is a common selling point for annuities, and this feature can provide peace of mind and financial security for retirees who are not comfortable with their nest egg being exposed to market volatility. Social Security benefits and pension plans share many of these characteristics. Before purchasing an annuity or automatically discounting the option, ensure that you understand the benefits, drawbacks, and potential conflicts of interest.
We are overwhelmed with various sources of financial information, and it can be challenging to sort the opinions from the principles. If you hear/see the words ‘always‘ or ‘never‘ when receiving financial guidance, your ears should perk up and take note. Education (academic and otherwise) is one of our greatest tools for building and preserving wealth, and I hope we will continue to challenge our automatic thoughts and assumptions when receiving or giving financial advice – myself included!
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