Transcript

Wiser Financial Advisor – Where to Invest First for Retirement

Hi, Everyone. Welcome to the Wiser Financial Advisor with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money.        

This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. We love feedback and we’d love it if you would pass it on to me directly: josh@keystonefinancial.com . Also please stay plugged in with us, get updates on episodes and help us promote the podcast. You can subscribe to us at Apple Podcasts, Spotify or your favorite podcast service. 

Let the financial fun begin!

Here on the Wiser Financial Advisor podcast, we talk about your money and financial wisdom—how to make wise financial decisions based on the experience of people who have walked before us.

In the Bible, King Solomon says in the Book of Proverbs, “Getting wisdom is the wisest thing you can do, and whatever else you do, develop good judgment.”

This past week I had a real treat. I had the opportunity to visit the Dave Ramsey Show in Nashville. I got to meet with Dave and his team and hear him speak at his Building Wealth live event, which was phenomenal. Dave’s new book Baby Steps Millionaires came out this past week and is well on its way to the top of the bestsellers list. He wrote the book following a Ramsey Solutions Study, the largest study ever done on millionaires.

Many of you have heard me talk about the study done by Dr. Stanley and Dr. Danko back in the early 80s. They did a study and released a book called The Millionaire Next Door. Many of you have either heard of it or heard me talk about it in the past, but this study by Ramsey Solutions is now the largest study ever on millionaires. In this study, they found two overarching themes with these millionaires—

Number one, they followed the Baby Steps outlined by Ramsey. Those steps make up a very clear, simple, and highly effective way to get out of debt and build wealth. Now, these millionaires may not all have known that the route they took was called the Baby Steps, but they followed the principles contained in those steps, nonetheless.

Number two, these millionaires in the study overwhelmingly believed that they were in control of their own destiny when it came to their finances and building wealth. They had the hope and faith; they believed that it was possible.

I’ll be sharing more about this in future episodes but wanted to give a shout out to Dave Ramsey and his team for hosting me and for putting on an outstanding event.

Today we’re going to talk about where to invest first for retirement. That’s a question we get a lot as financial planners. And before we get there, I just want to remind you that this show is brought to you by Keystone Financial Services, a wealth management firm based in the land of Love, Loveland, Colorado. At Keystone Financial Services, our mission is to bridge the gap between knowing and doing in the financial lives of our clients. We are here to provide unbiased advice and guidance. We are an independent fiduciary and all of our wealth advisors are Certified Financial Planners, the gold standard in the financial planning industry. Our goal is to replace uncertainty with confidence and clarity in your financial life by planning with somebody who has experience and has your best interests at heart. That is hard to come by these days with so much information out there and so much uncertainty in today’s world. Take the guesswork out of your financial future and contact us today by visiting www.keystonefinancial.com to schedule a free initial conversation with one of our Certified Financial Planners.

So, back to today’s question: Where to invest first for retirement? People will say: “There are a lot of different kinds of retirement accounts, so where should I start? I’ve got money; I’ve got my debt paid off and so forth; I’m ready to start investing. So tell me, which is better? My employer plan 401K? A 403B thrift savings plan? Or maybe a 457 plan?”

Depending on who you work for, many different plans might be available through your employer.

“Or,” people ask, “should I open up my own account—a Traditional IRA or Roth IRA? Or should I just bag all these things and invest in a taxable brokerage account?”

We’re going to dig into this, but before investing for retirement, I think it is important to back up for a second because a very common mistake I see people make is to try to jump ahead of themselves with regard to their planning. They try to start investing before they really have a good financial foundation.

There are a number of things that go into that foundation. Two of the places where people want to skip ahead, fall under those Ramsey Baby Steps. One is establishing a fully funded emergency fund that has three to six months’ worth of living expenses saved in it. This is not for glamorous traveling and that sort of thing; this is just enough to survive if things get crazy. This is the amount you need to get by per month. So figure out what that is. It requires some budgeting, and I know that’s not the most fun thing in the world for most people, but it’s important to know what it is that you’re spending and how much money you really must have on a monthly basis. Take that amount multiplied by three to six months and that’s how much should be in your emergency fund, which should be sitting in a savings account or checking account—someplace very safe and liquid.

The second thing you don’t want to skip over is paying off all of your debt except for the mortgage. The mortgage is a different bird but get all of your consumer debt paid off. That will be the Home Depot card, standard credit cards, student loans, any money that you owe to anyone, even if it’s a family member. Make sure it’s all completely paid off except for the mortgage before moving on to starting to invest.

Now, I know some people would argue with me on this and say, “Wait a second, the Home Depot card is 0% interest for a certain number of months,” and so forth. But this is a cash flow problem we’re solving, not a math problem. What we’re trying to do here is follow steps that are proven to succeed, which means getting nitpicky. This may sound crazy to some of you, but the interest on a debt doesn’t really matter as much as getting the debt eliminated. Our objective is freeing up cash flow and giving you peace of mind.

And remember that the borrower is servant to the lender, and that includes the mortgage. You want to pay off that mortgage no later than 15 years, which you can do by getting a 15-year fixed rate mortgage. If you’ve got a longer term mortgage, do the math. You don’t necessarily have to refinance; it could be that you apply extra principle on that mortgage to get it paid off in 15 years. The key is automation, so you don’t have to think about applying more principle to the mortgage every month. If you have to think about it, it’s not going to happen. And again, the objective is freeing up cash flow and gaining peace of mind.

Once you have accomplished those steps, you should be investing 15% of your gross income as a starter. Down the road we want to be putting away more than that for retirement, but to start we want to be shooting for 15%. When I say gross income, that’s your pretax income. In other words, if we’re thinking of what your salary is or if you’re paid hourly, how much do you make in a year? You’d look at that amount and apply 15 percent to that pretax income number and put it toward retirement.

Now, our rule is kind of simple when it comes to figuring out where to put the money. First, an employer match beats Roth and Roth beats Traditional. Let’s unpack this a little bit. Why does a match always beat everything else? Well, an employer match is a 100% return on your money. When you think about that, it’s free money if your employer offers a matching contribution. Statistically well over half of employers match contributions for their employees if they have a retirement plan. The most common match we see is 3% of yearly income. Sometimes we’ll see more than that, maybe 4 or 5%. We’ve seen some employers be very generous and match up to 10%.

Whatever that match is for you, don’t count that in the 15% of your income to invest. The reason is that a match is not guaranteed. What happens to those matching contributions from employers when we go into a recession and things aren’t so rosy on the balance sheet? Well, employers in that situation try to figure out ways to cut expenses, and sometimes they lay off employees or ask them to take a cut in pay, but I’ve seen them target matching contributions time and time again. Employers will suspend those matches. So it’s better to get used to 15% of your income going away into retirement investments. You don’t see it, it’s just gone. You spend what’s left.

Also be aware of eligibility when you start with an employer. Sometimes you’re not eligible to contribute right away. There have been a lot of changes over the last couple of years, some good, some bad. Just because your employer has a retirement plan doesn’t guarantee that you’re in from day one. Oftentimes there is a waiting period, sometimes not, but often there will be a three month, six month, or even one year waiting period where you’re not eligible to contribute. Also be aware that there are vesting schedules typically with employer plans. Employers will often put a vesting schedule in place for those matching dollars, and that means the money is not really yours until you’re with that employer for a certain number of years. There are different vesting schedules out there, and that’s beyond the scope of what we’re talking about today, but just be aware of that.

Sometimes after hearing this advice, people say, “No, I’m getting this matching contribution and I want to count that, so I can use other money elsewhere.” Just be aware that matching money may be at risk. Another nuance to matching contributions is that if you leave the employer early, you forfeit those matching contributions. The money goes back into the plan for other participants. If you stick around and a bunch of people leave, that actually might benefit you. But be aware that if you job hop quite a bit, you might be losing a lot of those matching dollars by making those job changes frequently.

One question that comes up is this: “What if my employer plan stinks? The investment options are awful and the technology is difficult to use and the statements aren’t clear and everyone in the company says they don’t contribute because the plan stinks.” Well, does it stink so bad that it’s worth giving up 100 percent return on your money? I’m not saying put all your money into the plan. If it’s a terrible plan, then do enough to get the matching contribution and invest elsewhere with your other dollars.

Let’s take an example here. Often, what we’ll see is a dollar for dollar contribution up to a certain percentage. So if a company does a dollar for dollar match up to 3%, that means a 3% match they’re giving you. That’s a 100% match on your money up to 3% of yearly income. Other ones might have a different schedule. They might say they do a 100% match up to the first 3% and then match 50% of the next 2%. Well, that would be 4%. Just keep in mind what percentage you need to be putting in to make sure you get those free dollars. Then if the plan stinks, it could be we just put in up to the matching dollars and nothing more.

Now, I mentioned before that match beats Roth and Roth beats Traditional. The reason we like Roth IRAs overwhelmingly as financial planners, is that what you’re doing when you’re figuring out where to put the money in Roth versus Traditional, you’re deciding when you want to pay the taxes, either now or in the future. We’ve done a whole episode on this in the past, so feel free to go find that one for a more detailed conversation about that. But Roth beats Traditional in the sense that when you’re prepaying those dollars, you’re taking the pain today, right? You’re not getting the tax deduction today, so when you put your dollars into that account, you’re feeling 100% of the tax burden and also 100% of the money you put into the Roth account is gone for right now. You’ll see it again because it’s still your money, still in your account, but in the long run, people tend to forget about that anyway.

If those dollars were put into a Traditional IRA, meaning you took the tax write-off upfront, then someday when it comes out, you will be taxed on those dollars. With a Roth, you do just the opposite. You put your dollars in and you get no tax benefit today, but then, someday when it comes out, it’s a tax free distribution as long as you play by the rules. (And there are a bunch of rules on that.) The way the Roth beats the Traditional over time is because over the years, what happens in that account? Unless you’re just a terrible investor and it never grows, what ends up happening is the dollars accumulate—not just because you’re putting money in but you should also get some level of growth, and if it’s there for a long time, it could be a lot of growth and that growth is also tax-free.

Whereas with a Traditional account, those dollars accumulate tax deferred but then they’re taxable when they come out, with a Roth, the dollars go in and then all growth over time is tax-free (as long as you play by the rules). When it comes to distributing those funds later on, you should get a tax-free distribution and so would your spouse if you die; so would your kids if you both die. Everyone gets the income tax-free, so it’s attractive from that standpoint. Why not bite the bullet early on and take the tax hit right now, then get the tax benefit later on. That could be huge tax-free growth over the years.

Clearly, there’s an advantage of time here, if you run the numbers. If you’re younger, especially, the Roth really looks attractive, because most likely you’re not in a huge tax bracket right now anyway. And later on will be your higher income years and maybe tax rates go up. That’s what we’re worried about over the years—tax rates going up. Historically they are low right now and regardless of your political affiliation, I think you’d agree with me that our debt levels in this country have gotten pretty crazy. We’ve got a lot of stuff to pay for, and things like Social Security and Medicare that aren’t even funded for the future. Those dollars have to come from someplace, and probably going to come in some part from tax increases.

So, you might be asking, “If I can pay the taxes today at today’s rates and tax rates go up in the future and the Roth dollars are tax free, couldn’t that be a trap?” And that’s something to think about. So what we might recommend here is some combination depending on your employer plan and your individual situation. We might be putting some dollars into the employer plan and getting the matching contributions depending on if they offer a Roth or Traditional 401K or both. If they offer both a Traditional or Roth 403B type of account, we’d look at your individual plan, because your employer dictates what options you’ve got within that plan. Believe it or not, it’s not really your account; it’s their account at Fidelity or Vanguard or wherever that account is sitting. It’s really your employer’s account. It’s their plan. You may have dollars in there, and you may be eligible to take those dollars out at some point, but just know that they control the plan and what options you’ve got, including Roth or Traditional. We’d look at it and at what investment options they’ve got, what fees and expenses, and how it’s all managed.

Outside of an employer plan, you can do either a Roth IRA or a Traditional IRA. By the way, I always want to qualify that there are certain income levels required and if you go over, you start to lose eligibility for some of these things, so we’d really have to look at your individual situation and your income sources—how much you make, how much your spouse makes, what your employers offer. We’d want to fine tune that to make sure you’re getting the most bang for your buck.

Also, age matters. It matters because there are requirements and waiting periods. Generally speaking, you have to wait until age 59 and a half until you start drawing dollars out of either one of these plans, whether Roth or Traditional without penalty. Currently, by age 72 you have to start taking money out of Traditional IRAs and 401K’s, even if you don’t want to. That’s called required minimum distribution, or RMD. There’s some legislation out there that would raise that age. It used to be 70 and a half and now it’s 72, so we’ll keep an eye on this. We’ve got clients over that age that are being forced to take RMDs every year, but only on Traditional assets. Roth IRAs do not have a required minimum distribution. (Unless you’ve inherited it from someone who isn’t a spouse, and then that’s a little different story. Then there’s an RMD that comes out within 10 years of the person’s death if they weren’t your spouse. So, if you’ve inherited that way, let’s talk.)

One thing to think about is, again, the direction of tax rates. I think that matters, so there could be some wisdom in thinking that through. If there’s money available now, you could pay the taxes now and not miss the money. Maybe it makes sense to do it that way. Over the years I’ve had probably tens of thousands of conversations with people, and I’ve never had a client that contributed to or converted to a Roth IRA or a Roth 401K and later regretted it in the long run, even if they had to pay some money up front. In some cases they do conversions from a Traditional to Roth and feel an ouch on that. Maybe they had to pay 5 or 10 or even 20 grand that year to be converting their Traditional to Roth. But I just haven’t had anybody come back and say, “You know what, I shouldn’t have done that.” Everybody likes it over time. It’s worth the pain in most circumstances.

Obviously it’s your money, so you’ve got to make that decision and if it’s just too painful to put all the IRA dollars into Roth, then do some of each so you’ve got some tax diversification. Tax rates likely will go up over time. It may not be on the doorstep right now, but eventually we’re going to see higher tax rates, so tax diversification will definitely help you over time. It gives you that flexibility in retirement of being able to take money from either source. You don’t have to draw as much money out every year when you’re in your retirement years.

One other thing I want to mention is that we often see people leave a string of old retirement plans from past employers. Sometimes it’s just easier because people are busy and they’re changing jobs and they’ve got a lot of other things to think about. Sometimes they forget or it just seems easier not to do anything with that old retirement plan. This is more and more common. People are changing employers and when they change, probably leaving some benefits behind, and mostly they leave retirement plans. Oftentimes when people join us and say, “Hey, we want to hire you as our Financial Planner, is there a way to simplify all this and start pulling this stuff together?” And there is. Many of these accounts can be consolidated, which can help you from an aggregation standpoint and sometimes from a cost standpoint. Keep that in mind if you’ve got older retirement plans, old plans where you’ve contributed over time. It’s important to look at that too as part of the whole picture, which is something we enjoy doing as Financial Planners.

If this is stuff that’s confusing to you, reach out to us. Or maybe it’s not confusing—often it’s the case that people don’t have the time to go through and get things squared away with all the pieces. They’ve got a lot of other interests besides financial planning. That’s just not how they want to spend their time in retirement or in the years leading up to retirement. We’ve all got the same number of hours in a day and that’s why we hire people to do stuff. And of course you want to hire good people for something like managing your wealth and making financial decisions. And as Dave Ramsey’s study showed, it really is key to be following the right steps, to have a process and be disciplined about it.

To sum up thinking about retirement, remember our target is 15% of your gross income invested for retirement and then being thoughtful about what options you’ve got. Match beats Roth and Roth beats Traditional in my book.

I hope that helps today. Feel free to reach out to us with any questions, because this stuff can be confusing, and we’re more than happy to take a bit of time to visit with you or a family member or a coworker who wants to walk through this.

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Have an outstanding week, and God bless.

This episode has been prepared for informational purposes only and is not intended to provide and should not be relied upon for tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors. Investment advisory services offered through Keystone Financial Services, an SEC registered investment advisor.