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Month: November 2018

YFP 076: Investing Q&A Episode

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Investing Q&A

On episode 76 of the Your Financial Pharmacist podcast, Tim Ulbrich, founder of Your Financial Pharmacist, and Tim Baker, YFP Team Member and owner of Script Financial, wrap up a month-long series focused on investing by fielding questions posed by, YOU, the YFP Community in this rapid fire investing Q&A edition.

Summary

Tim Ulbrich and Tim Baker tackle several questions during this investing Q&A episode.

  1. Q: Is it better to hold company matched retirement contributions to pay off 20-25% interest credit cards that I had to live off of between residency and my job? A: This may be a situation where you should hold off contributing to retirement and pay off your credit card debt quickly. Tim Baker would suggest to a client to look at strategies for debt reduction while growing income. The additional income can be applied to the debt. This is also dependent on how fast you can get out of credit card debt.
  2. Q: 401k Roth or before tax 401(k) which is the preferred option? The before tax 401k lowers taxable yearly income but we’ll pay taxes on the growth or the Roth 401k is tax free growth over time but higher taxable income at the end of the year. I can’t decide which is the best route. A: There is no one bad way as you’ll either pay tax now or in the future. If you think taxes today will be lower than taxes in the future, go with Roth. If you think taxes will be lower in the future, maybe wait to pay taxes. Tim Baker leans toward the Roth component.
  3. Q: What are your thoughts for proper investing strategies for current pharmacy students? A: Don’t invest anything as a student. Put that money into an emergency fund, toward your credit card situation, or put that additional money toward the accruing interest on your student loans. If you fall in the 10% that graduate without student loans, look at things like an HSA or IRA. Tim Baker offers a student/resident package with a reduced fee to help you establish a foundation and not miss out on wasted opportunities.
  4. Q: Can you go over how to rebalance a portfolio? A: When you set an allocation for your portfolio, over time it is going to drift. When it does, you need to rebalance it. To do so, you sell and reinvest. This usually happens once or twice a year. You can set alerts if an allocation drifts over 5%. Talk to your advisor, company or Tim Baker to do this.
  5. Q: Can you review pros and cons of active and passive funds? A: Active funds believe that the market is not perfectly efficient and that you can achieve above market returns through security selection, market timing or both. Passive investing means that you believe the price of the stock market is efficient and that you are unlikely to outperform the market on a consistent basis. 9/10 actively managed funds underperform passive funds.
  6. Q: Have you guys talked about HSA accounts and risks/benefits and how they fit into a long term financial strategy? A: Yes, in episodes 19 and 73. Follow-up question: Do HSA accounts need to be deposited throughout the year or are these ok to max out contribution limits anytime during the year? A: Like with an IRA or 401(k), it doesn’t matter when you max the contribution out.
  7. Q: How do you feel about investing apps, like Robinhood and Acorns? A: Tim Baker needs to do a review of them as this question comes up a lot. A lot of these solutions believe in low cost investing. Tim Baker likes the concept of building wealth over time and these apps may provide a way to save money without the emotional ties.
  8. Q: Can we do 401(k), IRA and Roth IRA all three? What are the limits in each? Which other options to turn to for tax saving purpose? A: Yes, it depends on the income limits. Tax saving purpose options are HSA or 529 accounts.
  9. Q: What is your thought on robo investors (Betterment etc)? I am a Federal employee, and so my retirement investments go into my TSP. However, I am looking at options for taxable investments beyond what I currently have with an advisor (the fees are making me consider other options). I know that index fund investing with Vanguard or Fidelity offer attractive low fees, but leave me open to issues with taxes on dividends unless I manually do my own tax loss harvesting (which I am reading and learning about, but don’t feel comfortable taking on my own just yet). Betterment does this for me at a higher fee than index investing on my own, but significantly less than an advisor. So, is something like Betterment “good enough” for taxable investments for those that want lower fees but still a more hands off approach? Thank you! I have loved catching up on your podcasts and am, 7 years post graduation, finally getting a better grasp on finances than I ever have. A: Tax harvesting is looking at the gains you make in a year off of your investments. You can sell loser stocks in your portfolio to offset your taxable gains with the goal of breaking even. Betterment or robo advisors can do this automatically and financial advisors also have tools for this. If you do this on your own, you have to do it manually which could take a lot of time.
  10. Q: If I’m a 1099, and have been contributing to a SEP IRA, and decided I want to take advantage of a backdoor Roth, what steps do I need to take to move my money to make it work? A: In a backdoor Roth IRA, you move money from a traditional to Roth IRA. This is a legal way to fund a Roth IRA.

Mentioned on the Show

Episode Transcript

Tim Ulbrich: Hey, what’s up, everybody? Welcome to Episode 076 of the Your Financial Pharmacist podcast. Excited to be here alongside our financial investing expert, Tim Baker, as we’re going to take questions from you, the YFP community in a rapid fire format. So Tim, we’ve got lots of questions on investing. And I think you’re on the hot seat today.

Tim Baker: Yeah, I think I’m ready. I’m ready to go. We have lots of questions, lots of engagement in the Facebook group, so hopefully we can get some of these questions answered.

Tim Ulbrich: Yeah, it’s been a fun month. I think this is a topic that we identified — as we were planning out the month of November, we identified we haven’t done enough on investing. We got that feedback from the community, we heard you, we listened, and hopefully we haven’t overwhelmed on the topic of investing. But knowing it’s such a critical part of the financial plan, we want to give it the attention it deserves. So if you haven’t been with us for the month, make sure to go back and check out the topics we’ve already covered in terms of priority investing, some of the behavioral biases, how to evaluate your investing accounts, DIY versus robo versus an advisor. And here, we’re wrapping everything up with a rapid fire Q&A format. And so for those that submitted questions via the YFP Facebook group, via LinkedIn, via email, thank you. And for those that have a question, make sure to join the YFP Facebook group if you’re not already part of that community. Or shoot us an email at [email protected]. Alright, here we go. Ready?

Tim Baker: Let’s do it.

Tim Ulbrich: Alright, Peter from the YFP Facebook group asks, “Is it better to hold company-matched retirement contributions to pay of 20-25% interest rate credit card that I had to live off between residency and my job?”

Tim Baker: Yeah, this is a great question. And I typically will say an addendum to the certainties in life are death and taxes. I typically will say the part three really should be if you have a match in your retirement plan, the third part is you probably should put that money in and get the max. Free money, you’ve heard us talk about that time and time again. So this might be one of the situations, however, that you might want to pump the brakes. And I think a lot, Tim, it deals with the timeline of things. So if this is something that we can put the retirement contributions on hold and do a gazelle-like sprint, as Dave Ramsey would say, and get through the credit cards, that might be where it would make sense. If we’re talking about a longer term horizon, we’re talking about a debt load of 20-25%, what I would actually do with a client here is possibly look at strategies for debt restructuring so you can get some breathing room. And then my thing is, OK, like how can we grow the top line? How can we grow the income? Not necessarily put the retirement contributions on hold but to apply all that extra income towards kind of the predatory debt levels. So it might be in your case, Peter, that it does make sense and it does make sense to put it on hold for a year or a short time frame and get through it as quickly as possible. But if I’m your advisor, I would say, hey, is there anything that we can do to make additional income so we can kind of keep the match going but also keep aggressive on the loans.

Tim Ulbrich: Yeah, and Peter, I’d point you back too to Episode 026. Tim Baker talked about baby stepping into a financial plan, specifically with a focus on consumer credit card debt and emergency funds. And I think that that would help even answer this question further. We obviously talked about in Episode 068 when we went through the pros and cons of the Ramsey Baby Steps. And via YFP team member Tim Church in the Facebook group saying, “Great question. Thanks for sharing. If you put your match on hold, how fast could you get out of credit card debt?” And so I think that’s the question of at what intensity, as you referenced, would you be able to get this paid off? And then obviously, how do you feel about having that 20-25% debt?

Tim Baker: It’s a great question by Tim Church.

Tim Ulbrich: Alright, Rachel from the YFP Facebook group asked, “401k Roth or before tax 401k?” So referring to a traditional 401k versus a Roth 401k. “The before-tax 401k lowers taxable yearly income but will pay taxes on the growth, where the Roth 401k is tax-free growth over time but higher taxable income at the end of the year. I can’t decide which is the best value.” Now, in Episode 073, Tim Church and I talked about the priority investing. We broke down the differences between traditional 401k, Roth 401k, we talked about IRAs. So I think what we didn’t get into as much in that episode was this whole idea of if I’m weighing between traditional contributions where I’m going to defer the payment of taxes to the future but lower my taxable income versus a Roth contribution where I’m paying taxes now, and I’m going to reap the benefits later. How do you weigh the balance of where to be prioritizing there?

Tim Baker: Yeah, and I think without being too simplistic, again, I think this is one of the things that I think sometimes we look at and we’re like, I don’t know what to do. And it’s almost like paralysis by analysis. And to me, I think it’s the same thing — and I kind of equate it to the avalanche versus snowball. There’s really no one bad way. I mean, you’re going to pay the tax either now or in the future. So you know, again, to back up just so everyone is crystal clear because we had a few questions around this. When you have a 401k, this is typically administered through your employer. Your employer will say, hey, Fidelity, Vanguard, whoever, we want this benefit for our employees as means to recruit and retain, we’re going to set up this 401k and we’re actually going to match. And we’ll say 3%. So it’s basically quarterbacked, in a sense, by the employer. So in this particular investment account, you basically put in a set amount, and everybody — these are 2018 numbers — can put in $18,500. So every year, that’s what you can put in. That’s what you can put in as a maxing out your 401k. Now, concurrently, your employer will incentivize you to put money in by matching a certain percentage. So they might say, hey, if you put in 3%, we’ll put in 3% and match that dollar-for-dollar. And there’s different things. They might say, we’ll match the first 3% and then 50% on the next 2%. So you have to put in 5% to get the full match and essentially, they’re putting in 4%. So I know there are a lot of numbers out there. In the 401k system, you basically have a traditional 401k, so that’s all pre-tax dollars. So it goes in pre-tax, it grows tax-free, and then when you distribute that in retirement, it comes out taxed. So in retirement, you’re going to be taxed on that amount you distribute. What’s becoming more and more popular these days is the Roth component of that. So anytime you see Roth, think after tax. So you’ll actually have what is basically almost like two subaccounts. You’ll have a traditional 401k, which you could put money into. And any match that you get from your employer goes in there. And then you’ll have what looks like a secondary account, which is your Roth 401k. So it’s going to look like two subaccounts, which is all after-tax money. And those monies cannot be co-mingled because you have a pre-tax bucket and an after-tax bucket. So the mechanics of that is it goes in after-tax, meaning you don’t get any tax deduction. So that money actually flows through onto your tax return. It grows tax-free, but in retirement, when you’re looking at a Roth 401k, and there’s $1 million in there, you actually have $1 million that you can distribute. Versus a traditional 401k, if you have $1 million in there, you don’t necessarily have $1 million because Uncle Sam still needs to take his bite of the apple. So those are really the same components. Now, in terms of your ability to contribute to that, it’s an aggregate. So between if you put $10,000 into your traditional 401k, you can only put $8,500 into your Roth 401k. So that’s the 401k. So to kind of go back to the question of which is better, if you think that taxes today will be lower than taxes in the future, probably best to go with the Roth option. If you think that taxes will be lower in the future, it might be worth to defer and wait to pay the taxes in the future. So and again, we’re really trying to look at the crystal ball here. I kind of lean more towards — and I think some of the studies that show, well, if you put money in pre-tax and it grows, that you’re going to pay a higher amount of tax on more money, essentially. And there’s studies that kind of support I think both sides. I think what I’m trying to say here is don’t get caught up in the minutia. I think if anything, I would go more towards the Roth component. But again, like when we talked about in the tax episode with Paul Eikenberg, which was Episode 070.

Tim Ulbrich: Yes.

Tim Baker: 070. There are different strategies out there. So it could be a tax strategy where you are looking to defer or you’re look to avoid. So it just depends, I think. If you have a handle on your tax situation, you’re going to know what makes the most sense for you and kind of your household. So lots of stuff there. I would be remiss to not mention IRAs here, which are similar in a sense that instead of the employer basically quarterbacking it, this is your own Individual Retirement Account that you are — there’s typically no match there. There is no match. But you’re basically putting money into an account and investing it on your own. And we can talk about that a little bit more.

Tim Ulbrich: Tim Baker, preaching and teaching. I love it.

Tim Baker: I’m trying. It’s a lot of stuff. I don’t want to confuse anybody.

Tim Ulbrich: No, it comes up so much. And I think your point’s a good one that we’ve talked with so many new practitioners that are getting that paralysis by analysis. So I think like anything else, take some action, get started, continue to learn, get some help along the way. But don’t do nothing because it seems so confusing.

Tim Baker: Right. And you can always — I mean, it’s the thing like year to year, you can always look at when you’re truly doing financial planning and kind of tax planning strategy, it can change year-to-year. So you might look at your pre-tax money and say, it doesn’t make sense to pay the tax on it today and actually get into some of the nitty gritty. I think for a lot of our listeners, just like how do I get started and what should be the bucket I focus on?

Tim Ulbrich: Yeah, and if you’re somebody who’s not resonating with the audio version of this, and you want to read this and be able to break it down, we spend a lot of time in Chapters 12 and 13 and 14 of “Seven Figure Pharmacist” breaking down investment terms and strategies and retirement accounts and taxable accounts. And so if you need some more time to digest it, look at it, you check that out, sevenfigurepharmacist.com. Alright, we’ve got a question — actually, we got several questions via LinkedIn this time, which was cool. Scott asked, “What are your thoughts for proper investing strategies for current pharmacy students.” So we’ve talked at length about student indebtedness, coming out, and I think when we talk about students, we tend to only focus on debt. So here Scott’s asking, well, what about investing? “I know that if I have time and I can invest and get compound growth, should I get started as a student? If so, what’s the strategy?”

Tim Baker: Yeah, so I typically give the least sexy answer to this question as I can because I get this like when we talk to pharmacy schools. And if it were me, I think the conservative approach to me would say I wouldn’t really invest anything as a student. If I’m a student, any additional income that I have, I’m either kind of going back to Episode 026 where we’re talking about baby stepping into a financial plan where we’re focused on do you have a solid emergency fund? Do you have — what’s your credit card situation looking like? And then from there, I think if I have a solid foundation, any additional money that I had that I want to — I’ve had students ask me about, hey, what do you think about the cannabis industry? What do you think about bitcoin? And I’m like, no, don’t do that. You guys have $160,000 in debt on average. So the least sexy answer is I would apply all of that money back to the interest on your loans that’s accruing. Because what happens is once you get through your P4 year, you pass your boards, you go through your grace period. And around this time of year, you’re going to hit repayment. Any of the interest that you’ve had that you’ve accumulated since the loans originated when you took the loans out — and that’s going to capitalized, which means that it basically moves from the interest side of the ledger to the principal side of the ledger. And now, that interest is accumulating interest on top of interest. So it doesn’t sound sexy, and I get it. Now, if you are one of the 10% of pharmacists out there that doesn’t have student loans, then I would definitely look at things like the HSA, the IRA, and obviously maxing out. And maybe it might be worth spending some time about how I typically advise clients to fill their investment buckets, which would be essentially get your match and your max in your 401k. And the example that I gave, if you have a 3% match, you typically want to put 3% in. And then typically, there you want to go into the IRA world, which is you setting up an IRA at Vanguard or wherever. And you’re putting $5,500 in per year, which is $458.33. So get into that monthly rhythm of putting that money in. And then you typically want to go back into the 401k and max it out, so that’s where you’re getting the $18,500. And then if you exhaust that, then that’s typically where you want to go into the taxable accounts that we’ll talk about here in a little bit. And what I didn’t say is probably along with the max of the IRA, in that second step, if you have a high deductible plan, maxing out the HSA, which is for a single person, $3,450. And for a family, it’s $6,900. So again, if you’re a student, I would focus on all the boring stuff. If you have the debt, if you don’t have debt, then that’s how to start filling your buckets. Now, if you don’t have an employer, obviously, you would want to go right to the IRA and start doing that. But it also depends — to kind of make this answer longer than it should be — is what is your goal? So if the goal of the investment is just to build wealth and put money towards retirement, that’s great. But if you’re investing for purposes like a wedding or something like that that you have a little bit more runway, then maybe you go straight to the taxable account. So lots of stuff, kind of lots of little pieces.

Tim Ulbrich: And I’m glad you brought up the 10% because we don’t talk about the 10%. I mean, if you look at the AACP data in any given year, when they publish the graduating student survey, 10-12% of students report they have no student loan debt.

Tim Baker: Which is a lot.

Tim Ulbrich: Yeah, it’s great. And I think we’re so often preaching to the 88% probably, but I think what just to highlight what you said there is keep your eye on the prize of graduating with as little student loan debt as possible. And I think it can be exciting to jump into investing or it can be exciting to do these other things that are opportunities there, but if you’re contributing some to investments while you’re in school, all while you’re taking on credit card debt or you’re taking on more cost of living, tuition and that’s compounding in interest, obviously, we’re kind of fighting against the effort that we’re doing. So I think this is a good time to talk about what you’re doing with the student resident financial planning services. We haven’t really talked much about that, but if we have students and residents who are listening, saying, I’ve got all these competing things, I’d love to work with Tim Baker talking about financial planning, what are you doing with the student resident package?

Tim Baker: Yeah, so I basically, what I do with students and residents — and I think it to me I think a lot of people are like, oh I don’t have the money or I’m too early in this process. But I think one of the things that I see is especially when it comes to like the foundational stuff, which includes cash flowing, budgeting, student loans, emergency funds, is it could potentially be — and not to speak in hyperbole — it can be hundreds of thousands of dollars swing in terms of your student loans and how we attack them. So what I’m really trying to do is present an offering that focuses on the student and focuses on the resident. So in those years, we can still work at a much reduced speed because I realize that there’s not a whole lot of income. But we’re setting the foundation to the financial plan. So the idea is to work with you guys, that population earlier, and then hopefully feed you into comprehensive financial planning like you and Jess are doing. But I think the swing — I know a lot of planners out there that say, hey, come talk to me after you’re through your residency. And I’m kind of thinking of a counterpart that I have that works with physicians. And my thought is that there’s a lot of wasted opportunity when you don’t have a sound financial plan in place almost immediately. And I think back, Tim, when we went back to USC and we were talking to basically the school, the pharmacy school out there, and we were talking to the P4s. And I was kind of like, I don’t know, probably begging is not the word, but like imploring their P4s, they’re in no better of a situation in that moment to be intentional about their finances.

Tim Ulbrich: Absolutely.

Tim Baker: And really be conscious of and having a plan for their student loans and especially if it’s like a PSLF option if they go into residency. There’s a lot of moving pieces there that I think if you can nail those first few years, that will set you up. So you know, I get fired up about it, and I like working with really all of my clients, but I think the students and residents, there’s so much opportunity there to get in front of.

Tim Ulbrich: Absolutely. So YourFinancialPharmacist.com/financial-planner will give you all the information for those that are interested in learning more. Michael and Audra via the YFP Facebook group are asking about rebalancing. So this idea of rebalancing a portfolio, can you go over how to rebalance, maybe what it means and a step-by-step process. And as you’re working with clients, how often do you do that?

Tim Baker: Yeah, so I think ultimately, when you set an allocation for your portfolio, over time, the investment portfolio’s going to drift. So the example that we can give in very broad terms is Tim, if you come into the office and kind of look at —

Tim Ulbrich: Your new office.

Tim Baker: New office, yeah, in Baltimore. Pretty excited about that. So if you come into the new office in Baltimore and you sit down and say, hey, I really want to save for retirement. I kind of put you through what’s called an investment policy statement. We’re going to build out like what that looks like. A big part of it is going to be the risk assessment. And the risk assessment, it’s going to basically return like an allocation. So it might say, when you answer these questions, you should be 80% in equities, which are stocks, and 20% in fixed income or bonds. So you know, there’s like a general rule of thumb out there — I typically don’t use this — but you could say as a general rule of thumb, just take 100 and then subtract your age, and that’s what you should be in equities. So if you were at 100, and you were 20 years old, you would be in 80%. And I don’t necessarily subscribe to that, but it’s kind of just rough math there. So say, Tim, you need to be 80% in equities and 20% in fixed income. Then you could essentially — and I think we’ve talked about this on the podcast, which a lot of financial planners would maybe argue with me. But I think that you can build a very diverse portfolio just essentially using two funds.

Tim Ulbrich: With low fees.
Tim Baker: With low fees. Basically, a total market fund and an aggregate bond fund. So you would buy, if you had $100,000, you would buy $80,000 in a total market fund and $20,000 in an aggregate bond fund. Now, I slice it a little bit thinner. You know, I’ll do more large cap and small cap and international. But I think if we use the example of one fund that’s 80% and one fund that’s 20%, over time, that’s going to drift. So over time, it’s going to be 85%, maybe 90% in that one fund and 10% in the other. So in that moment, your portfolio is more risky than essentially you sign up for. So what you would do is you would say, OK, now the portfolio has grown from $100,000 to $120,000, but I’m exposed too much because I’m in a 90% allocation, so you would essentially say $120,000 by .8, and that’s the target that you would want your total market, that equity to be in. So you would essentially sell off some and basically reinvest it into the bond to rebalance. Now, you typically want to do this once or twice per year because really, it just saves on costs. So typically, I have alerts on my investment accounts that basically alert me to trade. In most of the retirement plans, you can actually set these up. So if it drifts over 5%, then it will rebalance for you.

Tim Ulbrich: Yeah.

Tim Baker: So if you don’t know how to do that, obviously I would say to talk to someone at that, whether it’s Fidelity or whatever, talk to this, they can help you or reach out to me or another advisor that can help you with that.

Tim Ulbrich: So this might go into the behavioral biases, but I’ve found that I like having somebody else rebalance. Not because I think it’s difficult to do, per say, but what I found myself doing is I would go into my accounts, and I’d start sticking my fingers in it. And then I’d start saying, ooh, international, 10%. I keep reading the news, what’s happening with international stocks, and you start inserting all these biases. And I start adjusting and shifting things. Where if you and I agreed on an investment policy and strategy and we’re not reacting to the world of today but we’re looking at the long-term play, I’m less likely to do that, right? Or I’m going to at least engage with you before I make those decisions or whomever. So I think it just speaks to — and this gets to the next question about active versus passive funds, which I’m going to pose to you. But it speaks to that strategy of not necessarily leave it and forget it, but once you develop a strategy and a mindset, we’re in this for the long-term play. We’re not in it for the news of what’s happened in the DOW this week, right?

Tim Baker: Right.

Tim Ulbrich: So let’s talk about active and passive. So another question via the Facebook group, “Can you review the pros and cons of active funds versus passive funds?” I think we have some biases here probably. We’ve talked about those before. But what are the main differences and what should people be looking for?

Tim Baker: So an active investor basically believes, they believe that the market is not perfectly efficient. So if I’m an active investor, I basically think that I can achieve above-market returns through essentially security selection, market timing or both. So I’m smarter than the average bear that if I’m looking at large cap stocks, I’m going to be able to pick that better than what the market can essentially do. And then in terms of market timing, I can essentially see the future in a lot of ways. So the condition is I must determine when and under what conditions to both buy and sell. So the two methods that really people use to do active investing is technical analysis, which is really an attempt to determine kind of the demand side of the supply-demand equation of a particular security. So this typically relies on timing; it’s a lot of charts. You study past pricing, sales volumes, future trends. And you’re not necessarily concerned about hey, what’s Ford’s next line of cars? Or what’s the leadership at this company? It’s really about patterns. So that’s one way to look at it. The other way is the fundamental analysis where you’re looking at both kind of that macro and micro data. So you’re looking at interest rate increases, monetary policy, but then also specific to that industry or that company, productivity and profitability and earning potential. So that’s the active investor. The passive investor says, thanks but no thanks. I believe that the price of the stock market is essentially efficient, and then when I read that story in the New York Times about the cannabis industry or whatever or bitcoin, it’s been priced into the market long, long ago. So I’m not getting a stock tip or anything like that, I’m basically — I know that that is perfectly efficient. So the passive investor basically says, you’re unlikely to outperform the market on a consistent basis. And generally, that well-diversified portfolio that I just explained that has low cost is the better way to go, that you’re not going to — in the long-term — outperform the market. And the stats show that about nine in 10 actively managed funds underperform the passive funds. So inverse is true is typically, actively managed funds are more expensive. And that’s one thing that a lot of investors aren’t really aware of is what is it, how much money is actually going to be evaporating from their accounts because of expense ratio? And typically, the more you pay for the investment, the worse it is for the investor. So you would think if I’m buying a luxury car and paying more, I get better quality. So I would expect that. It’s not true with investments. Typically, the cheaper ones are the better way to go.

Tim Ulbrich: So for those interested in learning more on this topic, a few that come to mind, resources and books. We talk about obviously in “Seven Figure” as well, but “Simple Wealth, Inevitable Wealth” by Nick Murray is a great read. “Laws of Wealth” by Daniel Crosby is fantastic. And then “Index Revolution.”

Tim Baker: “Index Revolution” is such a simple —

Tim Ulbrich: Charles Ellis, is that who wrote that?

Tim Baker: Charles Ellis.

Tim Ulbrich: Yeah.

Tim Baker: Yeah.

refinance student loans

Tim Ulbrich: OK. So we’ll link to those in the show notes. But I think a great topic, and obviously when this topic comes up, probably the most famous quote on this is Warren Buffet, who is the active investor of all active investors, you know, really quoting that as he thinks about the future for his family, his spouse, in terms of advice, obviously what he had to say was probably most people are best off putting it in an index fund and letting it ride.

Tim Baker: Yeah, and he’s one of the people that on Planet Earth — and there’s probably, you know, a very small, like maybe half dozen that can kind of see what’s going on with the markets — part of it, and I think these guys admit it because they have access to investments. Like they just buy companies.

Tim Ulbrich: A little more purchasing power than we have.

Tim Baker: Right. So by and large — and I think that’s one, if you’re talking to people and really advisors who say, hey, I can beat the market, go the other way because nine times out of 10, even moreso than that, we have no idea where the market’s going to go. It’s better set an allocation, keep expenses low and kind of the singles and doubles approach.

Tim Ulbrich: Awesome. So Ryan asks via LinkedIn, “Have you guys thought about HSA accounts? Risks and benefits and how they fit into a long-term strategy?” We did in Episode 019, we broke down, you and I, HSA accounts and then also again in Episode 073, Tim Church and I talked at great length about the prioritization of the HSA, what are the contribution amounts, what’s a high deductible health plan. So for those that are itching, especially around — well, we’re post-enrollment now — but around that time, it’s a good time to be talking HSAs. But we had a follow-up question from Brynn on HSAs. “Do HSA accounts need to be deposited to throughout the year? Or are those OK to max out the contribution limits anytime during the year?”

Tim Baker: Yeah, I don’t think it really matters. I think it’s the same thing with like an IRA. Like some people will say, hey, I want to max out $5,500 immediately. Same thing with the 401k. I guess technically, you could front-load $18,500 in the first quarter of the year. With the HSA, if you $6,900 to put into it and you know that you’re going to have family medical expenses, I would have it really act as a pass-through if that’s the purpose of the account is to fund that and then use it if you are using it for medical expenses. Now I think what we’re trying to do in my household is more of using that as a self-IRA and really cash-flowing the health expenses and let the HSA go. So again, I think that’s a little bit of next-level in terms of having that bucket of money for that purpose. But yeah, HSA is a powerful — and I think one of the really good things about the HSA is that you could make $1 million and still get a deduction for that, which with the deductible IRA, most pharmacists, unless you’re a resident, you’re going to make too much to be able to enjoy the deduction.

Tim Ulbrich: Joseph via LinkedIn asked, “How do you feel about investing apps like Robinhood and Acorn?”

Tim Baker: Yeah, you know, we get this question so much that I really — I probably need to sit down and actually review all of these different solutions and come up with kind of an opinion on them. So I know a lot of advisors — and you kind of see this in the pharmacy world too, it’s like as technology creeps in, there’s almost like a defensive pushback like oh, I’ll never be replaced by a robot. I’m more of the mindset to embrace the technology and utilize it for good. So I think some of these ideas with rounding off purchases and slowly building wealth over time, I actually like that concept. Because from a behavioral perspective, we’re more likely to save that way than if Tim, if I was a financial planner and I said, “Alright, Tim, can we put $100 more per month into your IRA?” If you’re less of a feel, less of an emotional pull, I’m all in. So I think to Joseph, I think I owe you and a lot of the other people that asked me that question to kind of do a deep dive and look at these and see. I do know that a lot of these solutions believe in kind of low-cost investing. They’re not necessarily putting you in expensive funds. But I think an extensive look is probably something that we should have on the docket for 2019.

Tim Ulbrich: Alright. Via the Facebook group, Krishna asks, “Can we do 401k, IRA and Roth IRA all three? What are the limits in each? Which other options to turn to for tax savings purpose?” So again, in Episode 073, Tim Church talked a lot about the total contribution limits, you broke that down, preaching a little bit earlier, so we covered that. But the question of all three, the answer is yes with an asterisk, right? Depending on some of the taxable, the income limits and what not that we’ve talked about. What other options besides those do you turn to for tax-saving purposes? So if somebody’s listening that’s saying, “OK. I’ve got me covered in a 401k, got me covered in a Roth IRA. I’m looking to do more.” HSA…

Tim Baker: HSA would be the big one. Yeah, absolutely. And I think if the HSA is not on the table — and that typically is where you look at the taxable account, which you don’t necessarily get a tax benefit unless you’re doing some tax (inaudible), which we’ll maybe talk about here and that type of thing. But yeah, those are the major books that you want to focus on and really exhaust before you get into some of the other vehicles. And I think that’s one of maybe the drawbacks for like Robinhood and Acorns is I’m not sure if they’re necessarily IRAs or they’re taxable accounts. And typically, I feel more comfortable, unless it’s more of a near-term goal like a wedding or a trip or something like that, I would want clients to focus more on the retirement buckets before they would go into the taxable buckets.

Tim Ulbrich: Yeah, and obviously if kids are in the picture, taking advantage of 529s and the tax advantages over there as well. So Cory via email asks, “What’s your thought on robo-investors, specifically Betterment?” Now obviously in 075, we talked about DIY v. Robo and Hire a Planner, so if you haven’t yet heard that, go check it out so you get some more background on robos. He says, “I’m a federal employee, and so my retirement investments go into a TSP,” which we talked about in Episode 073. “However, I’m looking at options for taxable investments beyond what I currently have with an advisor. The fees are making me consider other options. I know that index fund investing with Vanguard or Fidelity offer attractive low fees but leave me open to issues with taxes on dividends unless I manually do my own tax loss harvesting, which I am reading and learning about but don’t feel comfortable taking on my own. Betterment does this for me at a higher fee that index investing on my own but significantly less than advisors. So is something like Betterment good enough for taxable investments for those that want lower fees but still a more hands-off approach? Thank you, I love catching up on your podcast. I’m seven years post-graduation, finally getting a better grasp on finances than I’ve ever had.”

Tim Baker: That makes me feel good.

Tim Ulbrich: Yeah. So Cory, thanks for the thoughtful question, appreciate the feedback. And I think these are the ones that get us fired up.

Tim Baker: Oh yeah.

Tim Ulbrich: So before going into the question maybe about pros and cons of a robo and building off what we talked about in 075, break this down on tax loss harvesting quick. I think this is kind of a next-level question from what we’ve talked about before.

Tim Baker: Yeah, essentially so when we depart from all of the retirement accounts, 401k’s, IRAs, in those accounts, your investments essentially grow tax-free. So the government basically leaves you alone from a tax perspective and any gains you might get inside of those accounts. On the taxable account, which is basically a brokerage or just an investment account that you have that is funded with after-tax dollars, it doesn’t grow tax free. And when you realize gains, you actually pay taxes on it. So what tax loss harvesting is is essentially you’re looking at any gains that you make throughout the year. So if I buy Tesla stock at x and then I sell it at x plus a 20% profit, I’m going to pay capital gains on that amount of money. What tax loss harvesting done is basically it looks at some of the less profitable, even loser stocks and positions in your portfolio, and you can actually sell those to offset your taxable gains. So you’re essentially trying to break even, in a sense, from a tax perspective. So this is a strategy that robo investors like Betterment can do automatically, and sometimes they do. And even a lot of financial advisors have tools that can do these things similarly. If you’re on your own, though, with a lot of these tools, you essentially have to do it manually. So at the end of the year, you might say, hey, I have a gain, so I don’t want to pay this amount of tax on it. So where can I sell an investment at a loss to offset those gains. And typically, you can basically offset whatever your gains are, and you can actually lower your income by about $3,000 per year, your ordinary income, if you have enough of a loss. So it’s kind of next-level. Betterment, I think boasts that you could potentially save .7-2.5%. Like that’s the range that you can ultimately do. I think those are a little bit exaggerated. To go back to the question, I think it’s really a matter of you get what you pay for, in a sense. Obviously if you’re doing low-cost investing on your own, obviously you have to do a lot of the legwork.

Tim Ulbrich: Yeah.

Tim Baker: Tim, you kind of talked about with your DIY approach when you were buying and selling houses, or selling house. It’s a time-suck. The Betterment approach is maybe that where they can do it automatically, but you’re going to pay 50 basis points on that. So you pay for that. And then an advisor could be where they’re charging you a fee and maybe an AUM fee. But you get a little bit more of the human element. So it kind of depends on, I mean, if I’m Cory, if this is something that you want to DIY, and your taxable account is not huge at this point — I’m not sure where you’re at — maybe you try to figure out the tax loss harvesting for yourself and take a crack at it. But you might get to a point where you have a million other things to do with life and you just would rather just slot it into a Betterment. But yeah, it’s definitely a strategy that I think if you can do consistently over time, you can essentially protect some of your gains because we talk about taxes and inflation are the big headwinds that are blowing in your face as you’re trying to build wealth over time.

Tim Ulbrich: Yeah, and I think this builds nicely off of what we talked about in 075 and really, have been talking about since Day 1 is emphasizing the point, which is important here when we’re doing a whole month on investing, that investing is one part of a very comprehensive financial plan, right? So if you’re doing the DIY robo route, making sure that you’ve got those other pieces accounted for and you’re not looking in one avenue, in a silo, only one bucket, and you’re really looking at the entire financial plan and picture as you’re moving forward. Alright, last question comes from Mo in L.A. via email. She asks, “If I’m a 1099 employee, and I’ve been contributing to a SEP IRA and decided I want to take advantage of a back-door Roth, what steps would I need to take to move my money to make it work?” I think that while Mo is asking this question of being a 1099 and a SEP IRA, which we talked about in 073, maybe to broaden this out to the community at large is the mechanics of a back-door Roth IRA. Now, we’ve defined what it is. But for those that say, OK, I don’t meet the income limits for a Roth IRA, so I know I need to do a back-door Roth, what is the next step they take?

Tim Baker: So typically, the breakdown is like anybody can contribute to a traditional IRA, but not everyone necessarily gets the deduction. For a Roth IRA, not everyone can actually contribute to a Roth IRA. So once you make a certain amount of money, those doors close to the Roth IRA. So typically, what the mechanics of is you can actually contribute to a traditional IRA and then essentially recategorize or do a back-door Roth IRA. So you basically move the money from the traditional to the Roth in an instant. And it’s a legal way to basically fund the Roth IRA. So that’s really the mechanics of it. Now, a SEP IRA, which we’ve outlined in previous episodes, is really the IRA for that Self-Employed Person. So for someone like me who I don’t have a TSP, I don’t have a 401k, I basically am — and really the traditional and the Roth IRA are not enough for me to be saving for retirement. So you can only put $5,500 per year in that. The SEP IRA is basically an investment account for the self-employed where you can put a lot more money in. It’s like $55,000 per year into that versus the $5,500 that you can put into the Roth and the traditional IRA.

Tim Ulbrich: So good question. We took a lot this week, and here we are, finally, end of November. We’ve hashed out investing. I think this is a series we’re going to really look back at and say, for those that want to dig in deeper into investing, go back to November 2018 where we covered a lot on this topic. So we’re pumped as a team to be wrapping up 2018. We’ve got lots of exciting content, new content, new ideas, things are coming to 2019. So we hope that you’ll continue on the journey with us. We hope that you’ll join us in the YFP Facebook group. And before we wrap up today’s episode, I want to again take a moment to thank our sponsor, PolicyGenius.

Sponsor: While paying off debt, buying a home and saving for retirement can be MUCH more exciting than ensuring the proper insurance coverage is in place, having the right coverage — not too much and not too little — is essential. And for pharmacists, our greatest tool to achieving our financial goals is our income. And that’s where disability insurance comes in. It protects your lost income if you’re sidelined by an illness or injury. And PolicyGenius is the easy way to get it done. They compare quotes from the top disability insurance companies to find you the best price. So if you rely on your income to get by, compare disability insurance quotes by visiting PolicyGenius.com. PolicyGenius will help you protect your paycheck at a price that makes sense. You can get started online right now. PolicyGenius. The easy way to compare and buy disability insurance.

Tim Ulbrich: And one last thing if you could do us a favor. If you like what you heard on this week’s episode, please make sure to subscribe in iTunes or wherever you listen to your podcasts. Also, make sure to head on over to YourFinancialPharmacist.com, where you’ll find a wide array of resources designed specifically for you, the pharmacy professional, to help you on the path towards achieving financial freedom. Have a great rest of your week.

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YFP 075: DIY, Robo or Hire a Planner?

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DIY, Robo or Hire a Planner?

On episode 75 of the Your Financial Pharmacist podcast, Tim Ulbrich, found of YFP, and Tim Baker, YFP team member and owner of Script Financial, continue YFP’s month-long series on investing by talking about the pros and cons of a DIY approach to investing compared to utilizing a robo advisor or hiring a financial planner.

Summary

On this episode, Tim Ulbrich and Tim Baker dive into a discussion of three strategies of investing: DIY, robo and hiring a financial planner. The DIY (do it yourself) route of investing means that you, instead of your employer or planner, will be in charge of all aspects of your retirement or investment. You’ll determine how much to defer into retirement accounts, what to invest in, make adjustments, and figure out to how to distribute funds at retirement, among other tasks. This route is becoming more popular most likely due to the fact that there are resources available and many advisors require their clients to have a lot of money to work with them. Pros of the DIY strategy are that there is a potential savings (if you are doing it well, etc.) and a feeling of empowerment. Cons are that there is a lack of accountability, that someone isn’t there checking or bringing awareness to potential financial behavioral biases you may have, and if you aren’t well-versed in the information, you could end up paying more.

Using an advisor is a strategy that lies between the DIY and financial planner routes. With this strategy, technology is used which allows you to simply click a link, answer a few questions, and fund taxable accounts. The pros of this strategy are that you don’t have to go through thousands of funds, the funds are automatically rebalanced over time, and the cost lands between .25-.5% on what’s invested. Cons are that there is no human interaction and that this only focuses on one part of your financial plan.

Hiring a planner means working with someone to act as the middle point between you and your investments. Pros to this strategy are the human aspect, the potential of having a comprehensive financial plan, the ability to create a diversified portfolio, and having someone act as a safeguard between you and your investments. Cons of hiring a financial planner are that the industry is structured so many planners are incentivized to grow your assets, may have a conflict of interest due to making more money off of your investments, and that a planner may not help you with credit card or student loan debt.

Mentioned on the Show

Episode Transcript

Tim Ulbrich: Hey, what’s up, everybody? Welcome to Episode 075, excited to be here alongside Tim Baker as we continue our month-long series on investing. We’re nearing the end. We’ve got next week coming up, we’re going to do an investing Q&A. But first and foremost, happy Thanksgiving, Tim Baker, to you and to the YFP community. So excited to be here.

Tim Baker: Yeah, happy Thanksgiving, Tim, to you and yours. And excited to get this episode going.

Tim Ulbrich: Yeah, we hope everyone’s having a great day, enjoying with family. We hope that you’re not nerding out on personal finance podcasts while you should be spending quality time with family. But if you are listening, please know that we appreciate it and that we’re certainly grateful for the community that has developed here over the past year. So we’ve been going along this month on investing. We’ve covered a lot of different topics and information, everything from behavioral aspects to investing, prioritization of investing, what to look for in your different investment accounts, the fees and so forth. And next week, we’re going to wrap it up with an investing Q&A. But here, we’re talking about the strategy of investing. Is this something you do yourself? Is this something you look at engaging with a robo advisor? We’ll talk about what that means. Or is this something you look at hiring a financial planner? Maybe for many people listening, there may be a different answer depending on the status of what you’re working on and what your preference is. So we’re going to reference some previous episodes throughout this episode, so let me throw them out here in advance. Episodes 015, 016 and 017, we talked at length, Tim Baker and I did, about what to look for in a financial planner, the benefits, different types of planners that are out there. In 054, we talked about why fee-only financial planning matters. And in 055, we talked about why you should care about how a financial planner charges. All of that feeds into the conversation here about DIY, robo or hiring a financial planner. So in terms of the structure and format of what we’re going to do, with each of these three buckets, we’re going to talk about what we’re referring to in a DIY approach, in a robo approach, in a financial planner approach. We’ll talk about the pros and potential pitfalls of each of those approaches. So Tim Baker, DIY. When we say DIY as it relates to investing, what exactly are we talking about? Whether listeners are thinking about maybe their 401k or maybe their 403b at their work environment, in the TSP, or they’re thinking about an IRA that’s outside of their work?

Tim Baker: Yeah, so the DIY, the Do It Yourself approach when it comes to investing, when we’re discussing things like the 401k, the 403b, the TSP, this is a little bit set up on a T-ball stand for you because the employer is essentially putting it in front of you and saying, hey, now that you work for us, we have contracted through an organization like a Vanguard or a Fidelity to basically have this investment account for you. So we’re going to cut you a deal, as long as you put money into it, we’ll match it. And we’re going to help you grow your retirement. So you can DIY that. And essentially, it’s a sandbox approach because you’re going to put in front of you a series of 10, 15, 20 — depending on the plan — investments that say, hey, for large cap, for U.S. large cap, you’re going to have four or five funds to pick from. From international, you might have two or three funds to pick from. From a bond, you might have some, it could be target funds. And if you’re hearing me talk about this and you’re saying, ‘What the heck is this guy talking about?’ then maybe having some help and not DIY-ing that — won’t be for you. Because the plan is defined, you’ll have basically a sandbox to work in. And essentially, what you’ll do is you’ll determine how much to defer into your retirement accounts. We’re talking your 401k, your Roth 401k, your 403b, what to actually invest it in — so a lot of people sometimes, they miss that step. So they think that once they put the money in there, it’s automatically invested. And some plans will be like that. But some plans won’t.

Tim Ulbrich: And they find out it’s just sitting there in a market fund.

Tim Baker: Right. I’ve seen that happen quite a bit. So you basically figure out how much you want to defer, what you’re going to invest it in, and over time, you have to kind of make those adjustments and do the rebalancing and things like that. And then when you go to retire, then you basically say, ‘Self, how do I distribute this in the most tax-efficient manner as possible?’ Whereas Tim, I don’t know about your dad, but my dad — well, my parents, really, they worked for the same company for 40 years, and the companies did that for them. And the pension manager would do that for them, basically would manage all those steps. So now, it’s kind of on us to figure that out. So that’s kind of the retirement side. If we’re talking outside the retirement, and we’re looking at IRAs, Individual Retirement Accounts, could be 529s, could be taxable accounts, that’s really where we’re going out into the market, essentially, and we’re looking at TD America, Vanguard, Fidelity, we’re going onto their website because we’ve heard of these companies, and we’re saying, ‘I want to open up an account on my own and basically do some investing on my own.’ So this is where you would open up a taxable account, open up a Roth IRA, and then the process is very similar except it’s just outside of the realm of what your employer is. So you’re opening up that account, you’re funding money from your paycheck. In then in that world, you’re essentially looking at a vast ocean, thousands and thousands of stocks and bonds and mutual funds and exchange traded funds, all the different things that could fit in these accounts. And you’re doing it in a way that hopefully is consistent with your beliefs about investing, if you have any, your risk tolerance, how you want to maximize or minimize, really, expenses and that type of thing. So I can tell from personal experience just the first time I ever opened up a Roth, I was at West Point. And I wanted to just dip my toe in the market. And I wanted to feel the feeling of basically buying a stock in a company.

Tim Ulbrich: Been there.

Tim Baker: And I think I bought like one share of Johnson & Johnson, and like after the transaction grew — and it’s kind of not very exciting — it was kind of exciting to see it, but I bought one share, which is the most inefficient way to do it because one share at that time was probably like $45. But then I paid like $10 —

Tim Ulbrich: The fee, yeah.

Tim Baker: Just to do the trade-in. But it was cool because at that time, I was like, well, technically, I’m part owner of this company, a .0 — add so many zeroes — 1% of Johnson & Johnson, so I would get documents that say, ‘Hey, these are when the board meetings are,’ but I really didn’t know what I was doing. And quite frankly — I know, Tim, we talked about this before — I probably had no business doing that, opening up an account like that because I didn’t really have a proper emergency fund. In the Army, a student is a little bit different, but there were so many other things that foundationally, I should have done before I even got to that point, but that’s kind of in a nutshell what the DIY approach is.

Tim Ulbrich: Yeah, and I think it’s — for many of our listeners, they’re probably thinking about, OK, most of my investing — maybe not all — but most of my investing’s happening with my employer-sponsored plan, so 401k, 403b. Of course that’s not everyone listening, many people have Roth IRAs or have taxable accounts that are out there, but what I’ve seen, Tim, is depending on the employer, how complex that is or is not can be all over the place. So for example, I work for the state. And they intentionally simplify options, you know, you’ve got two options in large cap, two options in international, they’re all index funds. Fees are pretty low. And I think they’re really trying to minimize some of the behavioral components that are there. But it’s still up to me, if I were doing a DIY approach and saying, OK, this is my asset allocation, this much stock, this much bonds, this much cash or cash equivalent or REETs or whatever. And then within there, what types of stocks I want to be investing in and then am I going to rebalance or not. Now, for other people — like a target fund I’m thinking of specifically — if somebody were to choose a target fund to say, OK, I’m going to retired in the year 2075, and that’s going to then set my asset allocation. The rebalancing is kind of happening along the way.

Tim Baker: It’s automatic.

Tim Ulbrich: Yeah.

Tim Baker: I would say from a target fund perspective, if you literally listen to what I just said about different types of funds like bond and international, emerging markets, small cap, large cap, and you’re like, ‘I have no idea,’ then go target fund. You probably will pay some type of premium for that service of it being rebalanced and becoming basically more aggressive to more conservative over time. But more often than not, I would rather you just pay the premium than have it sit in cash or be way too aggressive than you need be, depending on where you’re at in your life. But oftentimes, when I work with clients — and this is the opposite end of the spectrum, which is not DIY, it’s working with an advisor — I crack that nut, and I say, “Hey, client, you have 15-20 different options out there. And you’re in a target fund right now by default. I think we can do a little bit better given your situation and save on expense and things and break it out that way.” I think one of the things that you talk about (inaudible) and I’ve read a few books about the more choice that we are given, the more it causes that paralysis by analysis. And they say even like things like auto-enrolls. So we’ve talked about auto-enroll. There’s a lot of people that before auto-enroll really became a thing would work for a company for five, six, seven years, a decade, and never opt into their benefit of a 401k and the match there. Now, and this could be something the Obama administration put in, is that they’re incentivizing companies to basically auto-enroll employees. And then you essentially opt out of it if you want. And they’ve done a lot of studies in this with like Sweden and Finland, you have to opt out to not be an organ donor. And two countries that are very similar in a lot of ways, the opt-in, the percentage of people that were actually donating their organs was very low versus the opt-out. So a lot of this plays in. And we could do a whole topic, a whole episode, on behavioral finance and all the different biases that are out there. And I think that’s one of the things that maybe working with an advisor does. But it can be really confusing when you do it on DIY. It’s not impossible, obviously. But I think ultimately, my opinion — again, I’m biased because I do this for a living — is that I think it’s always good to have an objective look at your finances and say, hey, does this make sense? Is what I’m doing OK because I heard Uncle Tommy say this or my neighbor down the street said that, and I really want to know like sanity check this.

Tim Ulbrich: So obviously, as we think about the DIY approach, I think it’s fair to say that it’s becoming more popular — maybe not more popular but why is it popular in some regards. Accessing information is more readily available than it’s ever been before.

Tim Baker: Right.

Tim Ulbrich: Resources are out there. Just today, we had somebody ask in the YFP Facebook group, you know, I’ve heard of back door Roth IRAs, but what do I actually do mechanically. And we were able to quickly reference an article, get her a stepwise approach. So that information is there, readily available. I think that’s one of the reasons that it’s quite popular. What else do you think in terms of why people are going kind of that route of more of a DIY?

Tim Baker: I think it’s a little bit of an indictment of kind of my professional brethren. You know, there’s a lot of advisors out there that will say, “Hey, love to help you. But you have to have a half a million dollars before I can actually do work with you.” And the reason they do that is because they’ll charge based on assets, investable assets, which basically mean the assets they control directly, not what’s in your retirement account. So they say, “Hey, love to help you, but I can’t because I won’t essentially be paid enough.” So you have those minimum assets under management, AUM, requirements that basically for a lot of young population, just excludes them in general. I think one of the things that — and I was a little naive, no, I was a lot of naive to that is when I was looking at the profession of personal finance, kind of the whole 1% Occupy Wall Street was going on. So I think there is a distrust of large banking institutions and really financial advisors in general. And I think in a lot of ways, it’s well deserved. What a lot of people don’t know is that the majority, the overwhelming majority of financial advisors can legally put their own interests ahead of their clients, which when I kind of figured that out — and I was in that model when I discovered that the fee-based where you can earn commission fees, that blew me away. And it shouldn’t be that way. And I’m not saying that means 95% of the professionals out there are corrupted. But to me, is it should always be about the client, always be about what is in the best interests of the client, not necessarily mine. So I think that that perception is prevailing in a lot of ways. And that’s why I’m kind of fortunate when you talk about the work that we’re doing with you and Jess, it legitimizes, I think, what I’m trying to do. And I think what the fee-only world is trying to do is really say, there are services for young people that you’re not excluded. And by the way, I want to be on your team. And I want to get you to those goals that we talked about that whether it’s orca whales (?) or being able to retire at a certain time or whatever that is, that stuff jacks me up. And really, it’s the mechanisms of what the investments are and are properly insured that are just that supporting detail that I more or less have a playbook in my mind, and we just kind of plug and play depending on your situation.

Tim Ulbrich: Yeah, and I think I can say as somebody who went the DIY route for 10 years, you know, after graduation and obviously in working with you and Jess and I, I think too it’s fair to say for many listening, there’s just that overwhelming transition that happens where you’ve got new career, you’ve got tons of student loan debt, you feel like you’re trying to develop budgets and take care of all these other things. And part of it I think is just that feeling of being overwhelmed and my budget’s tight, I’m trying to figure out these things, and I may see additional fees or things and not necessarily be able to articulate the benefits associated with those.

Tim Baker: Right.

Tim Ulbrich: And I think it’s important that we just claim right off the bat what you just articulated nicely. Anytime we’re talking here about working with a planner versus not, you have to look at that under the assumption that it’s somebody who is good, who is acting ethically, who is acting, in our opinion, within a fiduciary standard because at the end of the day — we’ll get to some of the pros and cons of working with a planner — if you’re paying to work with a planner and you’re getting crappy advice, and you’re paying more in fees and things, now we’ve just put ourself up a creek and you might as well have gone the DIY route.

Tim Baker: Yeah, and I would say this — and I usually say this when I speak is I think one of the differences between financial planning, financial advisors and the profession of pharmacy is that the profession of pharmacy is actually a profession. You can take a test and be a financial advisor and give advice. You can do exactly what I do. The barrier to entry is very, very low, which means that you have — and you can see this maybe in other professions, not to call any out, but maybe like real estate and things like that where you take a test and you can sell houses.

Tim Ulbrich: Yeah.

Tim Baker: Sorry to all the real estate agents out there. But when you have such low barriers of entry, that basically muddies the water for a lot of hopefully professionals. And what I point to is someone that has the CFP mark, the Certified Financial Planning marks, and that are kind of following standards of ethics and all that kind of stuff. So I think that’s another reason why there’s lots of advisors out there that don’t necessarily know either what they’re doing or the other thing could be ignorance. So again, like when I was in the broker dealer world, I just didn’t know what I didn’t know. I thought I was awesome because I wasn’t selling proprietary products for maybe some of the bigger banks. So I’m like, oh, we can pick whatever products that we want from anywhere, whatever best suits you. But then I found out that there are other advisors out there that they’re not compensated based on product sales. It’s basically — the product and the advice is separated. And you know this in pharmacy, like anytime you mix the sale of product with advice, there’s conflict of interest. And you might see it with doctors and how they prescribe medications, those types of things. So to me, the model is broken from Jump Street that really, the consumer or client needs to be put first and everything else will fall into place. But I think that would, again, lead to why DIY is a popular — you know, just the savings cost and really, there are people that are thirsty. We’ve seen that from YFP. There’s people that are thirsty to learn. And it’s just something that is a huge void in our education system. We teach how to bake cakes and make ash trays in school, but we don’t teach them how to balance a checkbook or what credit card debt looks like or what student debt looks like.

Tim Ulbrich: Absolutely.

Tim Baker: So there’s a big void there, and I think people are — sometimes, we learn through pain and what we’ve gone through. And I think we can fill up a whole book of what we’ve personally done. And sometimes, it’s wisdom where we’re actually sitting down, writing through, reading “Seven Figure Pharmacist,” looking at all of the stuff that we have. You could learn a wealth of stuff on NerdWallet and Investopedia. So really, I think that’s a play as well.

Tim Ulrich: You know, one of the things I think is interesting as you were talking is — without getting too political here — when all the movement was going toward the fiduciary standard, I think it brought the public awareness and attention up a little bit that there’s not — most advisors are not acting in a fiduciary standard. And now that that really hasn’t moved forward, that may even, in some regards, lead people to think, well, now I know more about what fiduciary means, and I see that a majority of people aren’t that. That standard’s not progressing, so maybe a DIY route is where I’m going to go.

Tim Baker: Yeah, and really what Tim’s talking about here is in the last administration, basically the Department of Labor was essentially trying to push forward this standard, this fiduciary standard that said that basically the only accounts that they could touch under the Department of Labor were those basically issued by the employers. So they were saying any retirement account, 401k’s, 403b’s, and even I think IRAs, in this sense, have to be basically managed by fiduciaries that have the client’s best interests in mind. When the new administration came in, that legislation that was kind of being pushed through was squashed. So it did bring up I think some awareness that what is a fiduciary? And why aren’t all advisors fiduciaries? And there was a big push from the broker dealer world that says, hey, if we put this standard in place, then it’s going to shut out a lot of advice to kind of middle market and smaller — it’s going to shut out advice from that, which is categorically false. But it’s really around the protection of the income streams that insurance and other commissionable products generate. So I think we’ll eventually get there. It’s funny because we — I’m at different conferences, and Australia, you know, I’ve talked to advisors there that are like way ahead of us. They can’t believe that we don’t have a fiduciary standard across the board. Even their insurance products are similar. So I think we’ll eventually get there, but it could be a generation away just because of the lobbying.

Tim Ulbrich: So I think the pros of the DIY approach are obvious: potential cost savings with an asterisk — we’ll come back to that. Of course, it’s assuming that you’re doing it well and you’re controlling fees and you’re making the right decisions and so forth, you’re not being overtaken by some of the behavioral problems that can come up. Obviously, I think there’s a pro of empowerment and learning and being involved when you’ve got to figure it out, what does rebalancing mean? What does asset allocation mean? What do these funds and accounts means? So there’s a forced hand in learning. In terms of potential pitfalls, let me read you a quote from one of my favorite books, “Simple Wealth, Inevitable Wealth” by Nick Murray and get your reaction on this. He says that, “The twin premises of all do-it-yourself appeals are that most investors are smart enough, rational enough and disciplined enough always to select and maintain portfolios that are best suited to their long-term goals and that most advisors are venal and are stupid or at the very least, cost much more than they’re worth. The former premise is a fundamental misreading of basic human nature. The latter is just a self-serving mean-spirited lie.” Strong language, right? I mean, what are your thoughts?

Tim Baker: Strong language in a lot of ways. First, I had to actually look at what venal meant. So which, for you advisors out there, because I use the word fungible and gotten called on that. So venal means “showing or motivated by susceptibility to bribery.” So I think basically to summarize the quote, it’s we are perfect investors all the time. We know exactly what we need to do. We’re not emotional when it comes to this. And that advisors are stupid and basically fickle to wherever the money flows. I think that there’s probably truth and lies in both parts of that. What behavioral finance tells us and what’s becoming more and more is that a lot of our thoughts about finance is that people will — and it’s based on conventional economics — is that people will behave rationally, predictably and that emotions don’t influence people when they’re making economic choices, which is completely false.

Tim Ulbrich: We all know that. We’ve been thinking about it, right?

Tim Baker: We can outline a variety of biases, whether it’s anchoring or mental accounting or overconfidence, gambler’s fallacy, and we could maybe do a whole episode just on that. But frankly, as humans — and I do this for a living — and even sometimes for me, and especially when I’m looking at my own, we suck at it. Right now, we’re kind of in a market downturn. And I preach the long-term, I preach that over the course of the long haul, the market will take care of you. And that is a certainty. And I always joke outside of the zombie apocalypse or the Poles switching, the market will return 7-10%. It’s done it for 100 years. There’s bumps and bruises along the way, but when you’re in that moment, what I say in investing is that you should do the opposite of how you feel. So when 2008-2009 came around and we kind of are feeling a little bit of that now, you want to take your proverbial investment ball and go home. You want to get out of the market, you want to sit on the sidelines and stay in cash.

Tim Ulbrich: It should be game on, right?

Tim Baker: Right. And really, it should be opposite. If you are sitting on cash and the market is down, you should be chucking cash into your investments because essentially, it’s the one area of our financial life where we’re like, ah, I can’t believe that things are on sale and I want to get out of it. And then we kind of talked a little bit about the second part about advisors being venal and stupid. And again, I think part of that is earned in a lot of ways. But I would say by and large, I definitely operate that I think people are inherently good. But that doesn’t necessarily mean they’re good at their jobs or that they’re going to guide you the right way with regard to investing. And that’s why I think questions about that when you are potentially talking to a financial advisor is important, you know? And I think if people — one of the questions I ask prospective clients is if you had to make a list of all the things that you want your financial planner to have, what would that be? And the first one’s like, I want them to be trustworthy and I want them to communicate and I have access. But part of it is it could be an investment philosophy. If they tell me, I want someone to pick me the hot stocks, disqualified. I’m not your guy. I never will be your guy because I think the smartest thing I’ve ever said about investing in the stock market is that I don’t know where the stock market’s going to go. Nobody does. So again, I think that you shouldn’t be hiring a financial advisor to try to beat the market. By and large, they can’t do it. It should really be about managing the expectation, the behaviors, and specifically around this topic of investing.

Tim Ulbrich: I think one of the biggest pitfalls I see here — potential pitfalls — of the DIY approach is that lack of accountability, that risk of operating on an island. I know as I look back now on doing it myself, you may not feel it in the moment, but when there’s not somebody there to keep you in check and to call out the behavioral biases that we all are prone to, one I know for me and I’ve referred to before on the podcast is I knew that I shouldn’t be rebalancing more than I need to. I knew that once I set up my asset allocation based on risk tolerance, I should hold true. But you know, you log into your account, you see what’s going on, you start looking at things, and you say, well, maybe not so much of this or that, and you start messing around. And that’s why you hear the different studies saying the average return of the market is this, but the average person gets x, which is much less, because of our tendency to make those tweaks along the way. So I think accountability. I think the other thing too is that if you don’t have the right knowledge and so forth that you may end up paying more than the fees that are associated with a robo-planner, right? So we’ll link in the show notes, we wrote an article on the impact of fees and how fees can be a $1 million+ mistake alone if you’re not accounting for fees. And I know you helped me with a 403b account. I mean, we discovered fees north of — what? 1.5% I think?

Tim Baker: Yeah. And to kind of break this down, like one of the main suspects here is what’s called the expense ratio. So the funds that you are invested in, you know, mutual funds, exchange traded funds — not necessarily stocks — but the funds, there’s a manager that sits on top of that account and basically is buying and trading. And they pay themselves and they pay for office space and analysts and information. So basically, expense ratio is siphoning off money to keep the business profitable, in a sense. And if you have $100,000 in an investment and you have a 1% expense ratio, essentially you have $1,000 that is just evaporating every year from — and it’s not a line item anywhere, it’s just basically accounted for in the performance. And it doesn’t have to be that way because you can build a very investment portfolio for a tenth or even a twentieth of that. And my mantra’s always been, if I’m not getting the performance or it’s not safer for the same amount of performance, why am I paying 10 times, 20 times more? And that’s why we’re big proponents of some of the funds out there like Vanguard and Fidelity, they just rolled out a 0% expense ratio, and State Street and some of these ones that are very efficient for clients because again, you know, I think we’ve talked about this in a past episode is that the best indicator of performance is not star system ratings for Morningstar, it’s how you can drive expense down and keep as many hands in your investment — as many hands out of your investment pockets as — there’s platform fees and trading costs and expense ratios. Those are all things that — I mean, we have enough problems with the taxes and inflation that we need to be really protecting our gains, and a lot of that’s really keeping our expenses low when it comes to the investing part of the financial plan.

Tim Ulbrich: Yeah, if we’re going to hustle to put away money each and every month, like we’ve got to most out of it, right? And I think I love that’s what your mantra is keep those fees low. Obviously looking for performance as well, but I think of the statements I receive, and it has the tendency to say, well, I’m going to look at the one-year, three-year, five-year, 10-year performance. But I’m not really going to calculate what’s this 1% in total fees cost me? Or this 2%.

Tim Baker: Yeah. Well even that, like even advisors fall into this. They’ll say, hey, like I want to put my clients in 4- or 5-rated, and I only look at that. But that’s not the way to do it because typically, it’s a reversion to the mean. So what were high performing in 5-star systems, usually the script is flipped — pun intended — and those high performing, we’re buying them high and then they basically go low in terms of performance. So again, it’s just one that’s kind of the availability bias or what’s recently happened is we play on that. And it typically is the wrong move.

Tim Ulbrich: So that’s the DIY bucket. Let’s jump into the robo bucket. And you know, obvious pros and potential pitfalls. But here, we’re talking about somebody that maybe just heard this whole conversation about asset allocation and rebalancing and choosing investments and so forth and says, it would be nice to have a little bit of help around this investing piece there. And that’s really where robos come in. And obviously, there’s been I think — not a resurgence, a surgence of robo-advising, obviously, as they become more popular. I think they’ve been marketed a lot more than they were worth three or five years ago. So just briefly, what is a robo-advisor? Before we talk about the pros and cons.

Tim Baker: Yeah, so I would categorize a robo-advisor would basically sit in between DIY approach and working with a financial advisor. So typically, when you go the DIY route — and maybe we’ll put this link in the show notes, but NerdWallet has an article that says, “Best Robo-Advisors 2018 topics.” And the typical players in this are WealthFront, Betterment and those types. And essentially, what they do is they’re market disruptors in a sense that — and I remember working at my last firm, it took 38 pages to open up a Roth IRA. And essentially, what they do is you go to their website and you say, hey, if you want to open up — these are typically the kind of self-directed accounts. They’d be IRAs, Roth IRAs, taxable accounts. If you want to open up one of these, click this link, answer a few questions, and they automatically slot — and then fund it, so connect to your bank account or fund it from a different source. And you’re in a model.

Tim Ulbrich: Automatic selection there.

Tim Baker: Yeah, everything. So it’s really a method to bring technology and efficiency in a profession that needs it. So if you’re thinking, hey, I don’t want to wade through thousands and thousands of stocks and bonds and mutual funds and ETFs, and I want something that if I ask a few questions, they’ll automatically slot and rebalance over time — some of these rebalance. They’re robo, so they look at algorithms and they could rebalance daily, weekly, and you really just want to leave it alone. Then this would be typically something that you would do. Now, again, it’s going to cost you a fee to do that. So the typical ones, you’re looking anywhere from 25-50 basis points, so .25% on what you have invested to .5%. If we measure that against most advisors are probably 1%, north of 1%, just to kind of give you some perspective. But typically, you don’t have any type of human interaction. It’s go through this questionnaire, fund it, and then those dollars are invested on your behalf per an algorithm that is rebalancing over time. So again, like I’ve said this before is — and you kind of see this sometimes in pharmacy too where you’ll say, hey, I’ll never be replaced. The technology will never replace me. But robots are actually more efficient basically rebalancing than I would ever be because I’m not sitting by my computer every day. Just like you could make a case that robots are probably going to be more efficient filling scripts because of just the advances in technology. I think what robots will never be better at than me is that kind of one-on-one personal looking at the breadth of the financial picture. And I think the same is true when we’re talking about adherence and working with patients and all that kind of stuff. So they’re very synonymous in a lot of ways. But yeah, so I think the robo, I think it’s a good thing in terms of moving the needle in the market.

Tim Ulbrich: So you obviously mentioned the pro of convenience and access disrupted what was a very cumbersome, comprehensive process. I mean now, if you log onto one of those platforms you mentioned, it’s quick, it’s easy, asks you some question, you fund the account that you’re working on, and it sets up the asset allocation for you. And boom, you’re ready to go. So lower fees than a planner. So you mentioned, obviously, we’re assuming 0 or 1%ish. So here, we’re maybe .25-.5% so you can get a feel for that. I think the con you mentioned is a really good one. The lack of human element, engagement. And I think along that line, the thing I think about as the central pitfall here is that it’s focused on one part of the financial plan. You’ve been preaching since Day 1, and many of the financial planners that are out there are focused on one part of a financial plan. But what we’ve been preaching, especially for most of our audience, is that a financial plan runs all the way from debt to death. So we’re thinking about student loans, we’re thinking about budgeting and goal-setting and the right insurance. We’re thinking about end-of-life planning and home buying and kids’ college, all of these things. And when you’re looking at your month-to-month budget and your goals and what you’re trying to do, investing is one part, albeit a very important part, but it’s one part of your financial plan. And Betterment isn’t going to jump out and say, “Hey, by the way, are you thinking about your student loans and this or that?”

Tim Baker: Right.

refinance student loans

Tim Ulbrich: And I was thinking back to just our relationship over the last year of you working with Jess and I, we’re a year in. And we’ve done very little discussion yet — we’re going to get there more — but very little discussions on investing because we’ve been spending all this time on for us figuring out what’s our why and what’s our purpose, which we published in episodes 031 and 032, maybe 032 and 033. We’ll get that right in the show notes. We’ve been talking about goal-setting, we’ve set up sinking funds and budgets and making sure we have a good foundation and insurance. And now, we’re working on end-of-life estate planning. And so I think the biggest risk I see here is that — are you filling in all the holes? And are you prioritizing goals the right way if you’re only focused on that one part of the plan?

Tim Baker: Yeah, and this is something — full disclosure — that we have been offering, Script Financial, that we’re testing out. And essentially what I want to do is be able to for someone that doesn’t want to work with me directly, they can tap into a lot of the models and portfolios that I use for clients and it’s just a little bit of less service but less cost as well. And I think if you’re not in that, then you’re going to become extinct. So I think — and we’ll put a link to that in the show notes as well. If you are wanting to do more in the investment world, open an IRA or a taxable account, make sure you’re doing all the other things we’re preaching about and have those in place in terms of foundational. But then, you know, if you’re looking at just the wealth of funds out there and you have no idea where to start, we can definitely do that as well.

Tim Ulbrich: So two out of three buckets we’ve covered. We talked DIY, we talked robo, and now let’s move into hiring a financial planner. And as I mentioned in the beginning of the show, we have previous content on this that we’re going to talk about and build on a little bit. But make sure you check out episodes 015-017 that we talk through, episode 054 about what it means to be fee-only and episode 055 about why you should care how a planner charges. And before we get into the details here, I want to reference our site, YourFinancialPharmacist.com/financial-planner. Again, YourFinancialPharmacist.com/financial-planner. We’ve got lots of content in there, we’ve got a free guide about what we think you should look for in a financial planner, who may benefit most from one. And then we’ve got an extensive list of questions that we think you should be asking to make sure you’ve got somebody who’s really acting in your best interest as you’re going along the way. So whether that’s with us or somebody else, we want you to make sure that you have the right person that’s in your corner. So Tim Baker, as I was looking at some data on this, there’s a 2016 Northwestern Mutual study that only 21% of Americans hire a financial planner to assist them, despite more than 70% — and that 70% number coming from a Harris poll — indicating that they’re interested in receiving guidance. So we have a majority that says, I want it and I want guidance, but only about a fifth that are actually engaging with a planner. I mean, maybe we’ve already hit on some of this already earlier in the show, but what’s behind that?

Tim Baker: Yeah, I mean, and it could be a lot of the things that we’re talking about is sometimes I hear a lot with prospective clients is I didn’t even really know that there were people out there that focus more on younger professionals because they look at their parents’ planner and it’s kind of where their planner is patting them on the head and saying, hey, when you have some money, sonny, I’ll help you. Or I hear like a lot of these paternalistic, where it’s like “Do as I say,” you know, it’s not necessarily collaborative, which I like. But yeah, that’s shocking is that again, I think there was people, young Americans that want it but that it’s not hitting. And I think, again, I think that’s why — you know, I’m a member of the XY Planning Network, and I think when I joined the network — so it’s a group of fee-only fiduciaries, CFPs, that really want to bring financial planning to Gen X, Gen Y demographic that’s been by and large ignored. And I joined at the end of 2015, there was 200 members maybe. And there’s 700 with us now. I mean, that’s unbelievable growth. So I think it’s just there’s a void that I think is starting to be filled. And I’m encouraged by I think what I’m seeing in the industry. But I’m also discouraged by the fact that there are a lot of people out there that need help and have no idea where to go, whether it’s account minimums or — and sometimes, it’s like well my parents never had an advisor. Sometimes with money, we kind of repeat — you know, I have a lot of pharmacists say, “I’m the first person to go to college. Further, I’m the first person to get an advanced degree. The amount of money I’m making now is more than both of my parents combined.” And what often happens is that a lot of what they’ve learned about money comes from parents, and I’ve said that time and time again is what my parents taught me about money, essentially don’t have credit card debt, buy a house. And beyond that, it was wing it. Figure it out. And I think in that regard, we just don’t have good mechanisms in place. And I think I’ll call out some of the pharmacy schools and associations, I want more education around that because when you’re walking out with a potential mortgage-worth of debt, we better be damn sure that we kind of know how to approach that. And right now, I think we miss that. So when I asked a question, $160,000 of debt at a 6.5% interest rate, what’s that monthly payment? And then there’s crickets. And then they found out the payment is $1,800+, it’s like gees, that’s a lot of money.

Tim Ulbrich: I couldn’t agree more. And I think as Tim Baker gets fired up about needing more in the PharmD, I think we’re going to have to put the explicit rating on this episode. The little “E” next to the I.

Tim Baker: Yeah, oh man, I think we’re going to lose our family-friendly status.

Tim Ulbrich: So the obvious pros — we’re not going to rehash these because we’ve talked through these in the DIY and the robo is that of course, you’ve got the human aspect. You’ve got the scope of if done well, it’s comprehensive, right? So I used the example of the debt to death. You’re looking at all aspects. It’s not limited on one aspect like investing. You’re looking at your whole plan. One of the things I think is interesting, though, Tim, is there’s this continued myth that if I hire a financial planner, my outcome is going to be better because they’re going to help me choose the right stocks. And therefore, I’m going to outperform the market. And we, I think from our perspective, debunk that myth. And when we were working on the book, we were looking at research published that shows between about 1.8% and 3% better returns on average per year for those that are hiring a planner versus those that don’t. Now, I think people look at those numbers and think, oh, that’s because of them helping me choose the right investment. I think what we’re trying to make a case of, though, is if you’re saying no, it’s not because of that, then where is that positive return coming from?
Tim Baker: I think it’s really a matter of — and this could even be by accident in some ways, even in my past life in the broker dealer world is — you sit in between, from an investment perspective, you sit in between your client and their money. Most investment accounts, when the advisor is managing that for their client, there’s not two sets of hands in that. The client basically says, hey, I want you, the advisor to do that. So when the sky is falling, and the client calls — and I’ve had this here recently where the client says, hey, I really think that we should sell, typically, I do a timeout and let’s talk about it. Let’s revisit what we talked about in the investment. And although like I have the butterflies in my stomach too because my portfolio is affected, and I’m invested the same exact way that my clients are. I have to remind myself just like I have to remind the client that again, over the course of time, we adhere to, stick to our guns and adhere to the investment policy statement, the allocation that we put forth that is very diversified and low cost. It will take care of us. So I think because we don’t have the ability to get in and trade and that we’re kind of standing in between, it’s almost like a safeguard on hasty behavior. It’s kind of like what I tell clients that are just having a really bad time, just spending money on impulse or not being able to save money is anything that’s over $100, you have to have a 24-48 hour cooling off period. And if you are thinking about it in 24 or 48 hours, then maybe buy it. If you’re not, then that’s a good choice. So in the same way is this too shall pass when it comes to investments, there are brighter days ahead. And we’ve enjoyed a great, bold market, a great, hot market, and we’re going to have corrections. But by and large, sometimes it’s just the investor standing in between them and their accounts.

Tim Ulbrich: And I think you use the example of the advisor there sitting in between the investor and their accounts, I think it also goes beyond just the investment component. So as you’re working with clients and you’re asking them things about what are your hopes, dreams and goals, obviously one of those, you’re going to increase your net worth, you’re going to retire successfully, all of those things. But also if someone were to say, I really want to take some time off, 10 years into my career and do this. Or I want to make sure I’m spending more time with my family or at some point, I want to go part-time, I want to start my own business, or I want to get into real estate. Somebody who is really walking that path with you can turn back to you and say, hey, remember when we talked about this? Are we working towards doing that?

Tim Baker: Right.

Tim Ulbrich: And I think that gets to some of the cons because when you look at the industry, as you mentioned earlier, a lot of the industry is still structured in a way that incentivizes only the growth of the assets because if you’re being paid in an Assets Under Management model, you’re not incentivized to look at me in the face and say, hey, Tim, remember when you and Jess talked about Sam going to see the orca whales. Like you’d be better off saying, Tim, go open up the IRA so I can get my 1%.

Tim Baker: Right, or even more quantifiable than just saying orca whales, which is very important, is credit card debt.

Tim Ulbrich: Yeah.

Tim Baker: Or even student loan debt. I remember that question, and we answered that — I don’t know what episode it was, in one of the Ask Tim & Tim’s, and the advisor was basically saying to prolong the debt payments for the house and invest the difference. And to me, I look at that as like that is the advisor putting their interests ahead of their own. But like again, I’m seeing this more and more with new graduates, and this is something that I’m trying to crack the nut on with the offering that we have with students and residents in terms of financial planning is I’m seeing a lot of credit card debt. So if I walk into a financial advisor, typically because there’s an assumption of wealth and typically because they charge based on Assets Under Management, they don’t care to even know how to advise you on cash flowing, budgeting, debt management.

Tim Ulbrich: Do you have a will?

Tim Baker: Yeah, do you have a will? Those types of things.

Tim Ulbrich: Yeah.

Tim Baker: And I think maybe even the will is a little bit more because they want to protect the assets from the estate.

Tim Ulbrich: Yeah, that’s true.

Tim Baker: So we’re talking about the next generation of wealth transfer and the next few years is going to be incredible, but if I’m an advisor, then I’m paid more money if you put money into an IRA versus paying down credit card debt. And again, I think again, the planners, they want to be able to help their clients I think by and large. But they’re just not incentivized to do so. And I think that’s a problem.

Tim Ulbrich: And so as we talk about the cons here, I think they’re obvious. And we’ve highlighted some of them so far is that we’ve made a point of emphasis saying if you’re going to be working with a financial planner, there’s a lot of work that needs to be done to make sure that you’re working with the right planner that has your interests in mind, you’re asking the right questions about how they’re charging, fiduciary standards, do they have the right credentials? And it’s not any one of the answers to those questions is going to give you the obvious yes, this person is the person I want to be looking to work with. And one of the resources I would point our listeners to is one of my favorite books I read, “Unshakeable,” by Tony Robbins or maybe Tony Robbins’ ghostwriting team, you know, I’m not sure. But either way, he does a great job of outlining what we’ve been talking about here of the — I think he quoted maybe somewhere around 2-3% actually remain in that fiduciary category. But when you look at the wide variety of planners that are out there, the credentials that it takes to become a planner, the scope of services, how they charge, all the things that we talk about on our financial planner page at YFP, I think it can become very overwhelming to think, why am I paying for what I’m paying with these services, right? And what’s the value that I’m going to be getting from these services.

Tim Baker: Yeah, I think one thing to mention is I hear some prospective clients say, yeah, I heard you on the podcast, I’m thinking about working with you, but I’m also thinking about working with my parents’ financial planner. And one of the questions that I implore them to ask is what do they think about student loans? Because if student loans are a huge thing, again, 95% of advisors have no idea —

Tim Ulbrich: And they weren’t a big things for our parents, probably.

Tim Baker: Right, exactly. And they haven’t been trained up. So like they’ll say, oh, they just amortize our retirement. Or I heard one prospective client said that their advisor said, oh, these are no big deal. And you know, it makes my blood boil, in a sense, that we can do so much better. And the market is changing with how our economy is changing and what our financial picture is looking like. Like again, a lot of the stuff that we spend money on and that debts that our parents didn’t have, so we have to adapt accordingly, and it can be about training advisors on stock options and all that stuff that it’s still in the curriculum, but it doesn’t fit at all.

Tim Ulbrich: So just like pretty much anything else, all three of these buckets have pros and cons, right?

Tim Baker: Sure.

Tim Ulbrich: And we have people I know who have just commented in the Facebook group and reached out to us via email, we have people that are in all three of these buckets and are dominating. So I think the take-home point here is really, do a self-evaluation of where are you at and as you’re looking at investing as one part of the financial plan, which of these do you feel like really resonates most with you? Now, for those of you that are in interested in, hey, I really think I would benefit from a financial planner, I want to work with YFP and this, again, YourFinancialPharmacist.com/financial-planner. From there, you can get lots of information on what to look for, you can schedule a call with Tim Baker, learn more about him, see if that’s a good fit or not. And so I’d encourage you to check that out, YourFinancialPharmacist.com/financial-planner. Tim Baker, it’s been fun.

Tim Baker: Yeah, good stuff.

Tim Ulbrich: Look forward to wrapping this up next week. We’re going to do the Investing Q&A month of December. And again, to our community, happy Thanksgiving. We’re certainly grateful and thankful for you and the support that you’re provided. Have a great holiday and a great rest of your week.

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YFP 074: Evaluating Your 401k Plan

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Evaluating Your 401k Plan

On Episode 74 of the Your Financial Pharmacist podcast, Tim Church, Your Financial Pharmacist Team Member, and Tim Baker, owner of Script Financial and YFP Team Member, discuss how to evaluate your 401k plan and share information to help you understand some of the fees associated with it.

Summary

On this episode of the Your Financial Pharmacist podcast, Tim Church and Tim Baker discuss 401k employee sponsored plans. It can be overwhelming for new graduates or someone changing jobs to orient themselves with presented 401k options as most people have 20-30 investment options to choose from. All 401k plans aren’t created equal and it’s important to look at all fees that are being charged, even ones that aren’t seen, to determine which plan best suits you. If you need assistance analyzing possible plan options, Bright Scope is an excellent resource to help you find information.

Within a 401k plan, the rules of contribution and distribution are set by the IRS, however each organization has its own set of guidelines for the employee match and possible vesting requirements. For 2018, an employee can put $18,500 into their 401k and you and your employer can contribute $55,000 combined. Tim Baker discusses the difference between an employer match and vesting. A company encourages you to put money into your retirement account and also receives a tax reduction for the money they contribute. Employer matches vary from company to company, but it’s important to take advantage of them because the company is essentially giving you free money. Vesting helps mitigate turnover in a company and refers to how much ownership you have in a 401k. Companies may either offer graded or cliffed vesting.

If you are going to be leaving a job or if you have a new job that has a different 401k plan or provider, Tim Baker explains that there are four possible options to take: do nothing (let the 401k sit), liquidate the fund (cash it out), transfer to a new plan (move old retirement plan to a new one), or roll it over to an IRA. Typically, the best option is to roll it over to an IRA.

Mentioned on the Show

Episode Transcript

Tim Ulbrich: Hey, what’s up, everybody? Welcome to Episode 073 of the Your Financial Pharmacist podcast. Excited to be here alongside, in-person, with Tim Church to talk about prioritizing your investing for the future. Tim Church, how we doing?

Tim Church: Doing great, Tim. Glad to have you down here. How’s the weather feel?

Tim Ulbrich: It’s unbelievable. So here we are, mid- to end of October, came from northeast Ohio, below freezing weather, and they had to de-ice the plane before I got here. Came, landed, walked out, and I was overdressed, too warm for the day, saw the palm trees, so excited to be here. And Andrea has been an incredible.

Tim Church: Well, thanks. That’s basically why I’ve been down here the past seven years if you haven’t figured that out yet.

Tim Ulbrich: Yeah, for those of you that don’t know, Tim grew up in the Snow Belt and has made the wise decision of coming down south, where it’s a little bit warmer. So I get it now. I see what you’re doing here every day. So here we are, we’re talking about investing in and prioritizing in terms of the means in which people are investing. I think this is a long overdue topic. We acknowledge we haven’t done a ton on the topic of investing on this podcast, a little bit here or there. We did Investing 101 back at the beginning of the podcast, but that’s what this month-long series is all about. And probably one of the most important questions, most frequent questions we get is, so with all these options available, where should I actually be putting my money? And in what order? Especially for those that are coming out as new practitioners. So long, long overdue. Would you agree?

Tim Church: Yeah, definitely. I think so. And I think there’s a lot of great questions and things that come up with investing. And especially as you guys talked about in the Dave Ramsey episode, what comes first — investing versus paying off student loans and other debts. But I think this topic that we’re talking about just in terms of, OK, you’ve got these retirement investment options available. How do you prioritize and how do you say, OK, this is the first one I’m going to go after. And then after I do that, I’m going to go to the next one. And there’s a lot of questions that come up with that.

Tim Ulbrich: Absolutely. And I know as a new practitioner, new grad, I struggled with that myself, not only where does this fit within the other context of other goals, but also should I be maxing out my employer account? Everyone says Roth IRAs, putting money into those. I get emails about these brokerage accounts, what should I be doing and in what order? So we’re going to talk about that and give you our opinion on that topic. But I think it’s first important to start with what are the key principles of retirement savings? And as you and I were talking about this episode, we talked a little bit about inflation, taxes, and the power of investing early and often. So give us a little bit more information around those principles of investing.

Tim Church: Alright. So if you look at inflation over the years, over several decades, it’s typically 2-3% per year, which most savings accounts are not paying that, right?

Tim Ulbrich: Absolutely.

refinance student loans

Tim Church: And so when you look at that, you have to say, OK, what are the other options that are available to me that I can use to not only get a better return to beat inflation, but the other consideration is how do you do that with paying the minimal amount of taxes that you can so you’re keeping most of that money that’s growing?

Tim Ulbrich: Yeah, and I think just to add to that, the one advantage that young pharmacists have is that you’re coming out with a great income, typically — many graduates are coming out in their mid- to late 20s, you’ve got lots of years ahead of you in terms of investing a significant percentage and portion of your income and allowing that time for compound growth. So I like to think of inflation as kind of this gnawing thing that is just always coming after you. And I think it’s important to do that. And I read a couple books several years ago that if you really look at the impact that inflation can have on your finances, it’s something we don’t think a lot about, almost like fees on investment vehicles and other things. So inflation, taxes, and starting early and often. Now, Tim, it’s important that we talk about for everybody listening to this podcast, their personal situation is going to be different. And here, we’re going to talk specifically — almost in a silo of investing, right? And we know that those listening, some are looking at $100,000-200,000 in debt, other people are out of debt, personal life situations that are very different, all types of things. And so here, we’re really looking at if somebody has disposable income and they’re looking to invest that for retirement, in what order are they going to do that, right? So when I say if somebody has disposable income, what are we referring to there?

Tim Church: Basically, you’re talking about money that you have after you’re paying your expenses every month. So anything that you have to pay for your bills, how much it costs to live, what is that additional amount of money that you have that could be going towards investment? Many people, like you said, are flooded in debt, and so you could be listening to this episode, and saying, ‘What disposable income do I have? I’m just trying to survive. I’m trying to make it.’ But that’s really where we’re getting at is let’s just assume you’re going into this episode that you have money to invest to put in retirement accounts. Now, if that’s who you are listening to this episode and saying, I don’t have any money to put in investments because of the bills and things I have, well, it’s a pretty simple equation. That in order to increase your disposable income, you’ve got to increase your earnings, get a side hustle, work more hours, or you’ve got to decrease your expenses. And so that’s where really budgeting comes into play.

Tim Ulbrich: Absolutely, yeah. And I think that idea of it’s a simple equation — you either increase your earnings or you decrease your expenses. And just a shout out to the work you’ve been doing with the side hustle series, giving people ideas. We’ve got more content coming there. And just before we jump into the buckets of investing, I think it’s important that we are not — and we’ve had this conversation multiple times on the previous episodes — but we’re not going to have a conversation about should I be investing or should I be paying off my debt? And as I mentioned before, one of my concerns with an episode like this where we talk about investing or even the month-long series in a silo is that this is one part of a comprehensive financial plan. And you’ve got to look at the whole picture. So if you want more information on our thoughts about investing while in debt and how does that fit in with emergency funds and other life goals, head on over to episodes 068, where Tim Baker and I tackle that, where we reviewed the pros and cons of the Dave Ramsey plan. And I’m sure that’s evoked a lot of emotional reactions because it usually does.

Tim Church: Yeah, that was a great episode. And I think you guys did a great job talking through some of the controversy, but also some of the positive things that are in that plan and some of the behavioral aspects of it. And so when we’re talking about these major buckets, things that you can invest in for retirement, one of the things that came to mind, Tim Baker, he recently did an investing webinar. And he showed this image of actual buckets, and he was naming the buckets and putting one in. And I don’t know if when you were a kid, Tim — do you ever remember that show, Bozo the Clown? Do you ever remember that?

Tim Ulbrich: Yeah, yes.

Tim Church: And in that show, at the end of the episode — I think it was at the end — they actually were throwing ping pong balls into buckets. And they progressively — but there was a specific order that you had to put them in. And for some reason, he really evoked that memory when he was showing that figure. But it’s cool because it’s really, that’s what we’re talking about here. We’re talking about, OK, what’s the first bucket that you’re going to put your money toward? And then how do you go to the next level and what do you do?

Tim Ulbrich: And I think the visuals he used as well with the buckets in that presentation, it was a good reminder that these are vehicles and not the investments themselves. That’s an important point. We’ll talk more throughout this month. But when we talk about 401k’s, 403b’s, IRAs, etc., those are essentially the tax advantage shield in which you’re investing. But within that, you’re going to be choosing the individual investments, whether that’s stocks, bonds or mutual funds, etc. So let’s jump into these buckets. So probably for the vast majority of our listeners, they’re going to be presented by their employer with an option of a 401k, a 403b and what’s referred to as a TSP, which is a VA employee, right, that’s you.

Tim Church: Right, that’s the Thrift Savings Plan.

Tim Ulbrich: The Thrift Savings Plan. So we’re going to group these together because I think we throw around these words like we assume everyone understands exactly the implications of them. So let’s review quickly — a 401k, a 403b, and a Thrift Savings Plan, these are employer-sponsored retirement plans. So obviously, in order to get this benefit, you’re working for somebody. They’re going to offer this. And at what level they’re offering this benefit in terms of a match and what they can contribute is all over the place. And I think one of the things that we’ll talk in future episodes is as you’re looking at different jobs and comparing benefits and things, it’s a key thing to be looking at what is the benefit that you have? And I know the VA, that’s a pretty lucrative benefit on your TSP, is that correct?

Tim Church: Yeah, through the TSP — a couple different reasons. No. 1, they do offer a match up to 5%. But one of the other things is that they have very low fees in the funds that they have available. And I know that, Tim Baker always talks about that when you’re looking at different options within your 401k, is that you have to pay attention to those fees because even if you’re not seeing that change in your accounts, like over time, it can really eat at the earnings that you have.

Tim Ulbrich: Absolutely. And so let’s talk first — we’ve got 401k’s, 403b’s or TSPs, let’s talk about the traditional variety first because what has complicated this whole equation is that — you know, I remember when I came out of school, we were looking at primarily a traditional 401k or a Roth IRA. And now, we’ve got hybrids of these vehicles such as a Roth 401k or a Roth 403b, which I think has made this very complicated and probably make it even difficult to talk about it on the podcast in something like this. It’s good for a visual. So when we talk about a traditional 401k or 403b, essentially what we’re referring to there is that you are deferring the payment of taxes to the future. So those are a deductible in terms of income taxes today. You are not paying taxes on the contributions today. But when you go to withdraw those funds, no earlier than the age of 59.5 without penalty — and there’s a required minimum distribution at the age at which you’re beginning to have to force to take out that money — the maximum amount that you can put in as an employee into these accounts in $18,500 in the year of 2018. We’ve seen that climb each year by $500 or so. Now, there is an additional amount that you can put in after the age of 50. And that is $6,000, which essentially is a catch-up provision that allows you, if you’re behind in savings, to be able to save more beyond that $18,500. Now, what this does not include, which is a really critical, important piece here, is that $18,500 does not include the portion in which your employer would provide in the form of a match. Now, if you’re not familiar or haven’t heard of that term, match before, as Tim gave the example with the VA, it’s a 5% match. Essentially, 5% of his salary that he contributes, the VA will contribute dollar-for-dollar. And this is all over the place with employers. Some will do a 3% match, some will do a 6% match, some will do a dollar-for-dollar, some will do 50 cents on the dollar. But essentially as you’ll see when we get into the priority of investing, the match is free money. And that’s really the critical piece here. So why is this number important? Because what we’re referring to is that you obviously are growing money tax-free for a period of time. But ultimately, when it comes to being pulled out, you’re going to be paying taxes on that money. But if you make $100,000 — just out of simplicity — $100,000 per year, and you contribute $15,000 into your 401l, essentially you are going to be paying income taxes on $85,000. So it’s reducing your taxable income today. That money is growing all along, and you’re not going to pay taxes until the point you distribute it. And obviously depending on the income tax bracket you’re in and what the income tax bracket rates are at the time, you’re then going to be slapped with an income tax bill in the future.

Tim Church: Yeah, and I think that’s a good point to bring up is that when you’re looking at those account balances, somewhat really of an illusion when you’re looking at that bottom line if all of your contributions are traditional because it’s going to get taxed eventually, it’s just at what level is going to depend on where you are at the time when you’re making those withdrawals. Versus the Roth version — so many employers now offer the Roth version, and that’s even for the Thrift Savings Plan, where basically, you’re going to make contributions after-tax. So you’ve already been taxed on your income, and you’re going to allow those contributions to grow tax-free. So when I say tax-free, it basically is at the time at which you’re eligible to make the withdrawals, you’re not going to be taxed on that money. Now, that’s a whole separate animal in terms of determining what is best for you. Should you do traditional contributions? Should you do Roth contributions? And there’s a lot of different factors that can play into that, such as what your projected tax bracket’s going to be at the time of retirement or eligibility. And that could be a couple different things there. Does the government change the tax brackets? But then also, what is your projected income going to be? And things could obviously change with your job, so it’s really sort of difficult to predict everything. But there are some simulations out there online where you can kind of go through that.

Tim Ulbrich: And I think your point earlier about considering the tax implications is so critical to retirement planning because we often — and we’ve talked before on the podcast about a nest egg, how much you need at the point of retirement. Well, that number, if a majority of that’s in a traditional 401k, for somebody else that’s maybe saved a lot in a Roth IRA, which I’m going to talk about here in a minute, how that’s going to play out when you’re in retirement is very different in terms of the total amount that you have and how it’s going to be taxed. So I say that because I think the tax implications are a key planning piece as you’re thinking about exactly how much do I need at the point of retirement, and what’s going to be taxed? And what’s not going to be taxed when you get to the point of withdrawal? So again, 401k, 403b, TSP, max contributions in 2018 are $18,500 for the majority of people that will be listening to this podcast. And that number I think will be important because you often hear people say generally, to meet your retirement goals, you’re probably looking at somewhere around maybe 15-20% of your income that needs to be saved. So if you figure out the numbers, a pharmacist making $120,000, obviously you’re starting to get that point with the 401k, 403b, but there’s other vehicles that we’re going to talk through right now. And let’s go to that next one, which is an IRA. So Tim Church, IRA, Individual Retirement Arrangement, this one has different figures, different numbers, but also has a traditional form of it as well as a Roth form of it. So talk us through that one.

Tim Church: Correct. So this is something that anybody with an earned income is eligible for. They can contribute up to the max, which as of 2018 is $5,500. And there’s an extra $1,000 if you’re 50 or olders, so $6,500 if you’re 50 or older. But anyone who is earning an income can contribute to this. And what’s important is this is something outside of your employer. So this is something that you set up on your own, either through a brokerage account — but the other thing here too is besides what you’re able to contribute, if you’re a married and you have a non-working spouse, they can also contribute up to that limit. So technically, if you’re less than age 50, your household if you’re working and you have a non-working spouse, you can contribute up to $11,000 per year.

Tim Ulbrich: Yeah, and I think that’s an important provision. I know for Jess and I, so Jess is at home with the boys, she’s not working. But to your point, a non-working spouse, so for us, when we talk about a Roth IRA, we both contribute that $5,500 per year to be able to make that contribution. So this has both a traditional version as well as a Roth version. And again, I think that’s where it gets confusing when people hear Roth 401k, Roth IRA. So traditional IRA looks very much — obviously the numbers are different, the $5,500 per year — but looks very much tax-wise like a 401k or 403b in that you are — if you meet the income qualifications — you are deferring the payment of taxes to a later point in time. You know, many pharmacists don’t qualify in terms of the income limits for a traditional IRA.

Tim Church: Right. And if you look at the IRS has some different rules depending on whether you are covered by a 401k or whether you’re not covered by a 401k. But if you are, the phase-out if you’re single is $73,000. And for being married filing jointly, it’s $121,000. So if you make above those limits, you actually can’t deduct the traditional IRA contributions. And so that kind of leads into well then why would I ever do that, right?

Tim Ulbrich: Absolutely, yeah. And I think that we’ll talk in a minute about the back-door Roth IRA, and we’re going to actually in our upcoming Q&A episode even talk a little bit more about it. But when we talk about a Roth IRA, and I think why Roth IRA’s have all the rage these days, rightfully so, is that you are paying taxes today, that money is growing, but you are never paying taxes on that money again in the future. So if I were to contribute up to the max, $5,500 per year in a Roth IRA, and Jess did the same, that’s money that is being contributed that we’ve already paid our taxes on. So got my paycheck, paid taxes, then I make the contribution into the Roth IRA. I invest that money, it grows at some percentage every year, hopefully that compounds, let’s say that turns into a half million dollars, I’m at the age of 70, I start to withdraw that money, I’m no longer paying taxes on that money because I already paid taxes on the money before I put it into the account. Now, this gets into the whole debate about, well, would I be better off putting money in a Roth IRA or a 401k, and that gets back to the point that Tim Church made in terms of the tax brackets and what’s going to happen in the future, and largely, I think most people would agree we probably don’t know at this point in time. Now, this also has income limits to directly contribute. So for those that are single, the phase-out of contributions at $135,000. For those that are married filing jointly, there’s a phase-out that’s at $199,000. And so this is where you’ll hear people and you’ll hear pharmacists say, ‘Well, I really like that idea of tax-free growth, I pay taxes now, I’m not going to pay taxes in the future. But I exceed that income limit,’ and insert the back-door Roth IRA. Now, we could have a whole separate episode probably about the back-door Roth IRA. There’s some great tutorials, resources online. I know the White Coat Investor — just shout out to what he’s done — he’s got some great tools and resources about how people can go through that process. But essentially, what you’re doing in a back-door Roth IRA is you’re contributing to a traditional IRA, and then you’re converting that to a Roth component. And so we’re going to come back to that in our Investing Q&A. But all that to say if you’re somebody that exceeds the income limits of a Roth IRA, that does not mean you cannot take advantage of the benefits of a Roth IRA because of that back-door components.

Tim Church: Right. And I think the key is to keep in mind that it really is about the timeframe at which you make that conversion and whether there’s any gains on the money when you make the contributions to a traditional IRA. So if there’s any gains in between that conversion, you’re going to pay taxes on it. The other thing is too is that if you’ve already had past traditional IRAs, and you didn’t convert them, there can be some tax implications with that as well.

Tim Ulbrich: You know, the other thing I love about Roths, which I don’t think is talked about enough is that they do not have the forced required minimum distribution that come with the 401k or 403b. So if somebody’s out there thinking, you know what, maybe I’m going to be working until I’m 75 or 80 or maybe I have other sources of wealth, real estate investing, businesses, whatever, and you think you may not need that money at the required minimum distribution age in the early 70s that you’d be forced to take in a 401k or 403b, to me, that’s one of the great advantages of a Roth IRA, that you continue to let that money grow, and you don’t have to take it out. Alright, we’ve got another big bucket here, Tim, in terms of the HSA or the Health Savings Accounts, which we talked about in Episode 019 in details for those that want to go back and look at those. But give us the down-low on HSAs. I know you have this benefit through the VA, but this has the lethal triple-tax benefits, which are talked about often. So why are HSAs so powerful?

Tim Church: Well, exactly just like you said. It has the triple tax benefit. But yeah, this is one of the cool things that I started for my wife and I for this year for 2018 because I didn’t really know much about it before and what the implications were. But just going through as we talked about through YFP, I mean, it really has a lot of power. And the name itself is really a misnomer because you look at that and you say, Health Savings Account, so it’s just a regular savings account that I can use to pay health expenses, right? Well, not exactly. It can actually be an investment vehicle. It’s really an investment account in disguise. It really depends on your intentions or how you’re going to use it. And for some of these accounts, you have to have a certain amount before you can unlock those investment options. So for example, for me, is I had to have $2,000 in the account before I was allowed to contribute anything towards an actual investment.

Tim Ulbrich: Does that vary by who offers the accounts?

Tim Church: Yeah, I think it does. I don’t believe that that is an IRS stipulation. I think it does depend on the bank that is servicing the HSA.

Tim Ulbrich: I thought I saw that on the Facebook group, people were talking about, well, ‘with my employer, that number is different,’ so yeah.

Tim Church: Right. So like we were talking about is, how you’re going to manage this account really depends on that intention. So you could be using this account to strictly pay for medical expenses, and the benefit of doing that is you’d be paying for them pre-tax, which is not a bad thing. I mean, that’s a great way if you have anticipated medical expenses and you want to be able to pay for them with some tax efficiency, then that’s great. But you can also look at this from the perspective as I’m going to use my HSA as an investment vehicle. So you’re going to say, I’m going to pay for all of my medical expenses out-of-pocket, and I’m just going to invest the rest, and I’m going to treat it like an IRA or I’m going to treat it like my 401k in that my goal is to beat inflation to actually get some compound growth.

Tim Ulbrich: And is the thought here if you’re going to pay for your medical expenses out-of-pocket now and really let that grow, it sounds like it’s got the benefits of a Roth IRA plus you’re not paying taxes now. It’s got that, you know, the highs of the 401k, 403b and also the highs of the IRA. But at some point, are you forced to use those on medical expenses?

Tim Church: No, so it’s really kind of interesting about the account. So just to jump into that triple tax benefit. So the first one is that it will lower your adjusted gross income. So you can — any contributions you’re making to the account are tax-deductible.

Tim Ulbrich: Like a 401k and 403b.

Tim Church: Correct — if they’re traditional, correct.

Tim Ulbrich: Yep.

Tim Church: And then that account, any contribution that you put in are going to grow tax-free. Now, the withdrawals are tax-free as long as you can prove that they’re being used to pay for a qualified medical expense because otherwise, you’re going to pay a 20% tax if you take the money out before age 65 for a non-qualified expense. Now, if it’s after age 65, to my knowledge, there’s no additional penalty, there’s no additional tax. You basically, it’s like a regular retirement account. Now, here’s the caveat. So — and this is one thing that I didn’t know until I really got into it is that let’s say you contribute to an HSA over 20-30 years. And those accounts are growing, you’ve been investing them aggressively, and you’ve got some great growth on them. And let’s say you’re 60. Can you pull out some of that growth that you’ve had, some of that money that’s in there, but without paying taxes on it? And you can because the caveat is that if you keep track of all of your medical expenses you paid over that time that you’ve been contributing and can prove that you’re essentially reimbursing yourself, you’re not going to have to pay those taxes. But the key is really, you have to keep a good record of those receipts. What I’ve been doing is basically putting anything I have into the cloud, into Google Drive, and doing that for every year so I know exactly what I’ve paid and what I can technically claim as being a reimbursable expense.

Tim Ulbrich: Sounds like you need to develop like an HSA tracking expense app.

Tim Church: Yeah, there’s probably something out there.

Tim Ulbrich: Maybe it’s the next business project. But so unfortunately, not everybody has these available. But for those that do — and we’ll get into this prioritization — you often hear people putting these at the level of, OK, take your match, and then you think about an HSA. We’ll come back to that, but the reason that is and why they are so highly regarded in terms of priority investing is because of the tax benefits that you were just talking about. But not everybody qualifies. I know I haven’t with the employers I’ve worked with. In the state benefits, we didn’t have what was considered a high-deductible health plan. So to qualify, you have to be enrolled in a high-deductible health plan. What basically is a high-deductible health plan? Well, this year, for an individual, it’s having a plan with a deductible of at least $1,350. And for a family, that deductible is at least $2,700. Now, I think what we’ve seen with health insurance benefits pushing some of the costs back into the consumer and obviously increasing deductibles, we’ve seen more people being eligible for these. And I think it’s a great time to talk about this because of the time period around open enrollment. So if you’re somebody saying, do I have a high-deductible health plan? Do I not? Does my employer offer an HSA or not? Now is the time to look to see where this may fit in the context of your prioritization of investing.

Tim Church: And I would say that the two major reasons that my wife and I, we decided to switch from a traditional PPO health plan to a high-deductible health plan, really for the opportunity to contribute to the HSA but also the other benefit is that high-deductible health plans typically have lower premiums. So with the old plan, I was paying a lot more each month, but I wasn’t using any of the insurance that I was paying for. So if you’re relatively healthy, I think it’s a great option. So if stuff comes up, you might be paying some money out-of-pocket, but again, you wouldn’t have had that option otherwise to even contribute to an HSA. And you have to really look in the context of what your premiums are.

Tim Ulbrich: That’s a great point. And I think what you just said too speaks to the power of the emergency fund and having an emergency fund because if you can afford to take on that risk of, you know, maybe I’m healthy now, something comes up unexpectedly, I get slapped with a huge payment. Then ultimately, you’re ready to take that on, and you can afford it without feeling that risk of that. So what we didn’t talk about here with HSAs is the max contribution amount. So we talked about it with 401k’s and 403b’s or the TSPs, we’re looking at $18,500. We talked about with the IRAs, $5,500. What about the HSAs?

Tim Church: So as of 2018, if you’re single, it’s $3,450. And then if you’re self plus one or family, it’s $6,900. And an additional $1,000 if you’re 55 or older for catch-up. And this — just like the other accounts — this typically changes every year, every couple years.

Tim Ulbrich: So what I like, if you start to string these together between a 401k, a 403b, a Roth IRA or a traditional IRA, if you qualify as well as if you have access to an HSA, you can start to get to a point where you’re saving a significant percentage of your salary, probably more than many listening, especially in the contest of other goals. But nonetheless, you have the option to be saving a significant portion of your salary that has tax advantages. And I think that’s key because one of the last things that we want to talk about here is the taxable or brokerage accounts. And so with the taxable brokerage accounts, why I said that previous point I think is important is that I see a lot of new graduates getting ads and promotions for some of these apps and tools and things that are out there. But they’re investing outside of the tax-advantaged accounts. And so I think as we talk about taxable or brokerage account, where we see this fit in is once you’ve exhausted all your other tax-favored retirement plans, this probably is the final option that you’re looking at because of the loss of tax-shield capital gains taxes that you have to pay, etc. So good news here is if you get to the point where you max out everything and you’re looking for options, there’s lots of options out there in which you can invest. But don’t get too far ahead of yourself if you’re not taking advantage of the match or other tax advantages that we’ve talked about previously. So last one quickly before we talk about prioritization of these buckets would be the SEP IRA. And I think this is timely because of your side hustle series. And so maybe we have people out there that own their own business, are starting their own business, want to, and to me, when I see information about a SEP IRA, that makes me want to start some businesses because you’ve got some really good advantages with retirement options. So what is a SEP IRA? And what flexibility and freedom does it give you in terms of retirement?

Tim Church: So a SEP IRA stands for a Simplified Employee Pension. And basically, if you’re self-employed, you own your business, you have this opportunity, this benefit available to you. And this could be in addition to a 401k that you have available. So this could be something that you’re doing on the side, an additional business you own. But one of the advantages is that there’s a lot more money you could potentially contribute versus what’s available with a 401k or IRA. I mean, it’s a huge difference. But obviously, you have to be making that much money up to that certain point to be able to. So right now, what the guidelines are, is that you can contribute up to the lesser amount of either 25% of your compensation or $55,000. But when I see those kind of numbers — like you’re shaking your head here, Tim — that just gets people fired up, I think, to say, hey, what if I was able to bring in an additional amount of income that I’m no longer capped out at this 401k, this IRA max that’s there.

Tim Ulbrich: Yeah, reason No. 403 to start a side hustle, right? I mean, when you see those numbers, and it gets me fired up even for the work that we’re doing that to your point, it’s dependent on compensation, obviously, you mentioned the lesser of those numbers. But in addition to other retirement vehicles, you can obviously make some great headway if you’re in a position to do that. OK, let’s jump in now. We’ve set the stage, we’ve spent a decent amount of time talking about the buckets, which is important because before we can talk about prioritization, we have to know what we’re talking about. What is a 401k? What is a 403b? What is a Roth? Now, a couple disclaimers here that I think we have to talk about because we’re probably going to take some flack regardless, which is OK. But not everyone is going to agree with the prioritization that we’re talking about. Not necessarily that there is one right way in terms of order of investing. Now, we’re going to give a framework on that that we think many listening will follow, but to my point earlier, everybody has different personal situations in terms of income earned, in terms of other financial priorities, in terms of other goals, when you want to retire, all types of variables that may come into play in terms of how you actually execute this.

Tim Church: Yeah, and I think like there’s a lot of people out there that are really into real estate, and they look at that as even taking priority over some of these retirement accounts because either they’re all-in or they’re confident that they’re going to get good returns there. And I think that’s great. I think for some people, that is an awesome option. But I think here, like you said, we’re talking in the context of, OK, let’s focusing in on these retirement accounts and just really try to figure out, well, what is the best order?

Tim Ulbrich: Yeah, and I think the other situation I think about, Tim, is those that are on fire about the FIRE moment, the Financial Independence Retire Early, waiting until 59.5 to access your accounts may not be the goal they’re after. And so you know, obviously again, this to me really speaks to the power of sitting down with somebody like Tim Baker and financial planning and talking about what are your goals and then putting out a map to be able to achieve those. The last thing I have to say here as a disclaimer before we jump into the prioritization — if Tim Baker was here, he would make me say this — is what we are saying is not financial advice, right? So we don’t know of the thousands of you listening, we don’t know what your own personal situation is. So we’re looking, again, down the lane of investing. If you have disposable income to invest, this is the priority we think you should consider. But we’re not saying, run out and do this tonight. You’ve got to think about the context of the plan. OK, No. 1 — I think everyone agrees with this. I mean, maybe there’s a person or two out there, maybe? I don’t know.

Tim Church: I haven’t seen — so what I was looking at to see what else is on the Internet and some of the other bloggers, I think this is one thing almost everybody I think actually agrees on.

Tim Ulbrich: For how much disagreement there is.

Tim Church: Right.

Tim Ulbrich: So No. 1, as you may have guessed it, is the employer match, right? No surprises here, most people agree on this. You are getting free money from your employer. If you don’t take it, you’re leaving it on the table. And so we even believe, we talked about this in the Dave Ramsey episode, Episode 068, the match has to be a priority in your financial plan, even in the context, I think, of student loan debt — maybe a different conversation depending on personal situations, but you have to take that money. Now, for you, you mentioned that 5% match. So let’s just use a hypothetical. Somebody’s making $100,000, they put in 5%, they get 5%, that’s $10,000 of tax-deductible retirement savings that are going to grow over time. You’re putting in 5, your employer’s putting in 5. And again, as I mentioned earlier, you’ll see this in different situations in terms of the percentage of salary match. It may be 5%, 6%, 3%, no percent, dollar-for-dollar, $.50-per-dollar. And so it’s all over the place.

Tim Church: Or what you get. What have you gotten at schools? You’ve gotten like 14%?

Tim Ulbrich: Well, I’m unemployed right now.

Tim Church: Oh, OK.

Tim Ulbrich: But you know, yeah. So you know, I’m lucky to work in the state teachers’ retirement system, which we actually are forced to put in. I remember when I was in the grinding out of paying off debt, it was painful. But we are forced to put in 14%, and there’s some fees and things that shakes out to that they match around 10%. So it’s kind of a forced combined contribution of about 24% total, which is really nice. But the downside is I actually don’t get any Social Security, so I won’t receive that Social Security benefit in the future if it’s there. But we’ll see. So No. 1, employer match. Now, No. 2 is HSAs or Health Savings Accounts. Take the employer match, and I think what often, people do right after the employer match is they just go up and maybe max out their 401k. I think what you’re making a point here is maybe after that match, move into the HSA if you have it available.

Tim Church: Yeah, and I think — but even going back to is that a bad option of putting more money in your 401k? So I think like in the context, which is interesting here is that really, even if you’re switching up the order on some of these, like really, it’s still not a bad decision. The decision to actually put money into the accounts to grow is a good thing. But I do think, you know, the HSA with that triple tax benefit, it’s hard to argue against that, right?

Tim Ulbrich: Absolutely.

Tim Church: I mean, it’s such a powerful tool. I think Dr. James Daly of the White Coat Investor, he calls it the Stealth IRA, which is pretty cool.

Tim Ulbrich: I love it.

Tim Church: Because it’s basically like you’re getting the opportunity to contribute to another IRA if that’s your intention behind it. But it can really be a powerful way to get some additional retirement savings.

Tim Ulbrich: I do have HSA envy. I don’t have access to an HSA, so unfortunately, yes, great match, but I wish I had that HSA option. So No. 1, we said employer match. No 2, HSA triple tax benefit makes a whole lot of sense.

Tim Church: If available, right? Because not everybody’s going to have that.

Tim Ulbrich: Right. High-deductible health plan, you may or may not have it. Now, No. 3 here, we’re getting into the IRA. And really what we’re getting at is the Roth IRA component. And obviously, for those that don’t meet those income qualifications, they would have to do a back-door Roth IRA. But what we really want to take advantage here is the tax-free savings that are going to happen over time. You’re paying taxes today, you put the money in, it grows tax-free, you go to pull it out, you’re not paying taxes anymore. So even though this doesn’t have the same maximum as the 401k, 403b’s, you’re not going to be able to have these be equally weighted, pre- and post-tax, right? $18,500, $5,500. To me, I see this as the way that you’re balancing out getting to the point of retirement, you’ve got some free and post-tax savings. So if I’m maxing a Roth IRA at $5,500 per year or back-door Roth IRA to get there, and then I’m putting in $18,500 in a 401k or 403b, of course I’m going to have more in accounts that are going to get taxed than I am in accounts that are not going to get taxed. But I’m balancing those out a little bit.

Tim Church: It also depends too if you have a Roth 401k, then also that could be after-tax contributions, so it’s possible you could have both. You could do the Roth IRA and a Roth 401k and basically putting everything in after taxes and then letting your accounts grow tax-free. I think going back to what we talked about is that since most pharmacists are not going to get the deduction if they contribute to a traditional IRA, it sort of makes sense to always go to the back-door Roth. Well, I think one of the interesting questions — and this has come up before — is why would I not just go up higher on my 401k versus contributing to an IRA? And really, you know, the way I look at that is either one is still a great option in terms of the contributions. The difference, really, is that with the IRA, this is outside of your employer, which means a lot more options.

Tim Ulbrich: Yeah. And that’s why you hear — we won’t get into it here — but that’s why you hear when you switch employers, there’s value in rolling that over into an IRA where you can unlock those options. And one of the things I’ve seen with Tim Baker’s help is the variety of what people have available to them in an employer-sponsored 401k or 403b, both options and fees, good or bad, is all over the place. Some have very limited options, very high fees, and maybe their employer doesn’t even really recognize or acknowledge the value. Others are maybe working with a Fidelity, Vanguard, whomever, have tons of options, can get low-fee accounts. So this really is an individualized decision.

Tim Church: I totally agree because when I look at the Thrift Savings Plan, one of the benefits of a Thrift Savings Plan, like we talked about earlier, is there’s such low fees on that. And so with a situation like that, I mean, you could make the argument that either one is going to be fine. But if I’ve got really low-fee options that are getting great growth, then I may go and try to max out my 401k or increase prior to going to the IRA.

Tim Ulbrich: And I think your point is a good one. At the end of the day, we’re splitting hairs, right? If you’re having this debate, there’s lots of opinions, lots of nuances, but at the end of the day, you’re doing a good job, you’re being intentional, you’re saving for the future. I tend to favor the prioritization of really maxing out the Roth component before I go back to max out the traditional 401k because of what I mentioned earlier and having that balance of pre- and post-tax, but again, people have different answers on that based on what they think is going to happen in terms of the tax component. So just going back in order here — your employer match, HSA, IRA component, we talked specifically about the Roth component of an IRA or a Roth 401k, right? And then going back to your traditional 401k, maxing that out to the $18,500. Now, if you get to this point, and you’ve taken an employer match, you’ve maxed out an HSA if you have it, you’ve maxed out the IRA, and you’ve maxed out your 401k, you’re crushing it.

refinance student loans

Tim Church: Yeah, I mean, that’s pretty awesome. I mean, I’m not quite there yet. But it really is encouraging to see those numbers as a goal, really, to say, hey that’s where I want to be.

Tim Ulbrich: When you put those numbers together, we’re talking about $18,500, another few thousand, another $5,000 — you’re saving a significant percentage of your salary, looking at several million dollars with compound growth over 30-40 years. Now, after we max out the 401k or the 403b or the TSP, then obviously, if people have access to a SEP IRA, they’re going to take advantage of that. Now, after Step 5 here…

Tim Church: Right, that would depend if they have some kind of additional income or potentially they don’t work as a W2 employee, and their main business or their main job is as an employer or a small business. So that actually could be somewhat reversed depending on the situation and depending on what kind of job you have.

Tim Ulbrich: What you have available, yes. I think what we’re doing here is — before we get to the last one, which we’re calling them brokerage accounts, which as I made the point earlier, these don’t have the same tax advantages that all these others do. So what we’re advocating for is really maxing out the opportunities you have to save in tax-advantaged vehicles and then ultimately if you’re still looking to save more, personally I’d probably advocate for maybe some real estate investing, some business stuff, other things before even brokerage accounts. But you’ve got lots of options available.

Tim Church: You’ve got lots of options. And the other thing too is as long as you’re not continually trading fees and different things like that, I mean, capital gains tax is actually still tax efficient versus some other things that are out there that you’re going to get taxed ordinary income.
Tim Ulbrich: Absolutely. Fun stuff. We covered a lot here, packed full of information. I think this is one we’re going to hopefully go back and say, ‘Hey, you got questions about the different investing buckets, prioritization, go back to Episode 073, we’ve got some great information.’ And this is a reminder, for those of you that haven’t yet done so, if you could leave us a review in iTunes, if you like what you heard, or whatever podcast player that you’re listening to, we would greatly appreciate it. Also, if you haven’t yet done so, make sure to head on over to YourFinancialPharmacist.com, where we’ve got lots of resources, guides, calculators, that are intended to help you as the pharmacy professional on your path towards achieving financial freedom. Tim Church, this has been fun and looking forward to coming back and finishing up the series.

Tim Church: It’s been great, Tim.

Sponsor: Before we wrap up today’s episode of the Your Financial Pharmacist podcast, I want to again thank our sponsor, PolicyGenius. Now, you’ve heard us talk many times before on the show about the importance of having a solid life insurance plan in place. And while we know that life insurance isn’t the most exciting or enjoyable thing to think about, actually having a life insurance policy in place is a really good feeling. And PolicyGenius is an easy way to get life insurance online. In just two minutes, you can compare quotes from the top insurers to find the best policy for you. And we know that when you compare quotes, you save money. It’s really that simple. So if you’ve been avoiding getting life insurance because it’s difficult or confusing, give PolicyGenius a try. Just go to PolicyGenius.com, get your quote, and apply in minutes. You can do the whole thing on your phone right now. PolicyGenius, the easy way to compare and buy life insurance.

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YFP 073: How to Determine the Priority of Investing

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How to Determine the Priority of Investing

On Episode 73 of the Your Financial Pharmacist podcast, Tim Ulbrich, founder of Your Financial Pharmacist, and Tim Church, YFP Team Member, continue a month-long series on investing by talking through the various retirement/investing options available, key principles for retirement savings, and how to prioritize investing. The figure below summarizes the episode and lists the 2019 annual contribution limits for the most common retirement accounts.

Summary

On this episode, Tim and Tim discuss the priority of investing in retirement and other accounts. Tim Church mentions savings accounts aren’t able to pay the amount that inflation rises each year (2-3%), so it’s important to think about other options on how to beat inflation while paying a minimal amount of taxes. This episode focuses on using disposable income to save for retirement.

Most listeners will be presented with the options of 401(k), 403(b), or TSP (Thrift Savings Plan) and will be offered matches that vary employer to employer. There are a number of different retirement options available. Traditional varieties, Roth, IRA, backdoor Roth IRA, HSA, and SEP-IRA are all potential options for investment. Details are given for each of these options, including how much you are able to contribute as an employer each year and the age in which you can withdraw funds.

When it comes to the priority of investing, YFP suggests that you first use the employer match as it’s free money and should be the priority in your financial plan. Then, use the HSA if it’s offered to you as it carries a triple tax benefit and is a powerful tool for investing. Roth IRA and Roth 401(k) can then be contributed to as they offer tax free savings over time. You’ll pay the taxes today, allowing your money to grow tax free. After that, max out your traditional 401(k) and then a SEP- IRA. If you’ve maxed out the contributions to everything previously mentioned, you can then consider investing in brokerage accounts.

It’s important to note that this is not a financial plan, everyone’s situation is different and therefore different options may work better for you than what is mentioned, and not everyone will agree with what we have suggested.

Episode Transcript

Tim Ulbrich: Hey, what’s up, everybody? Welcome to Episode 073 of the Your Financial Pharmacist podcast. Excited to be here alongside, in-person, with Tim Church to talk about prioritizing your investing for the future. Tim Church, how we doing?

Tim Church: Doing great, Tim. Glad to have you down here. How’s the weather feel?

Tim Ulbrich: It’s unbelievable. So here we are, mid- to end of October, came from northeast Ohio, below freezing weather, and they had to de-ice the plane before I got here. Came, landed, walked out, and I was overdressed, too warm for the day, saw the palm trees, so excited to be here. And Andrea has been an incredible.

Tim Church: Well, thanks. That’s basically why I’ve been down here the past seven years if you haven’t figured that out yet.

Tim Ulbrich: Yeah, for those of you that don’t know, Tim grew up in the Snow Belt and has made the wise decision of coming down south, where it’s a little bit warmer. So I get it now. I see what you’re doing here every day. So here we are, we’re talking about investing in and prioritizing in terms of the means in which people are investing. I think this is a long overdue topic. We acknowledge we haven’t done a ton on the topic of investing on this podcast, a little bit here or there. We did Investing 101 back at the beginning of the podcast, but that’s what this month-long series is all about. And probably one of the most important questions, most frequent questions we get is, so with all these options available, where should I actually be putting my money? And in what order? Especially for those that are coming out as new practitioners. So long, long overdue. Would you agree?

Tim Church: Yeah, definitely. I think so. And I think there’s a lot of great questions and things that come up with investing. And especially as you guys talked about in the Dave Ramsey episode, what comes first — investing versus paying off student loans and other debts. But I think this topic that we’re talking about just in terms of, OK, you’ve got these retirement investment options available. How do you prioritize and how do you say, OK, this is the first one I’m going to go after. And then after I do that, I’m going to go to the next one. And there’s a lot of questions that come up with that.

Tim Ulbrich: Absolutely. And I know as a new practitioner, new grad, I struggled with that myself, not only where does this fit within the other context of other goals, but also should I be maxing out my employer account? Everyone says Roth IRAs, putting money into those. I get emails about these brokerage accounts, what should I be doing and in what order? So we’re going to talk about that and give you our opinion on that topic. But I think it’s first important to start with what are the key principles of retirement savings? And as you and I were talking about this episode, we talked a little bit about inflation, taxes, and the power of investing early and often. So give us a little bit more information around those principles of investing.

Tim Church: Alright. So if you look at inflation over the years, over several decades, it’s typically 2-3% per year, which most savings accounts are not paying that, right?

Tim Ulbrich: Absolutely.

Tim Church: And so when you look at that, you have to say, OK, what are the other options that are available to me that I can use to not only get a better return to beat inflation, but the other consideration is how do you do that with paying the minimal amount of taxes that you can so you’re keeping most of that money that’s growing?

Tim Ulbrich: Yeah, and I think just to add to that, the one advantage that young pharmacists have is that you’re coming out with a great income, typically — many graduates are coming out in their mid- to late 20s, you’ve got lots of years ahead of you in terms of investing a significant percentage and portion of your income and allowing that time for compound growth. So I like to think of inflation as kind of this gnawing thing that is just always coming after you. And I think it’s important to do that. And I read a couple books several years ago that if you really look at the impact that inflation can have on your finances, it’s something we don’t think a lot about, almost like fees on investment vehicles and other things. So inflation, taxes, and starting early and often. Now, Tim, it’s important that we talk about for everybody listening to this podcast, their personal situation is going to be different. And here, we’re going to talk specifically — almost in a silo of investing, right? And we know that those listening, some are looking at $100,000-200,000 in debt, other people are out of debt, personal life situations that are very different, all types of things. And so here, we’re really looking at if somebody has disposable income and they’re looking to invest that for retirement, in what order are they going to do that, right? So when I say if somebody has disposable income, what are we referring to there?

Tim Church: Basically, you’re talking about money that you have after you’re paying your expenses every month. So anything that you have to pay for your bills, how much it costs to live, what is that additional amount of money that you have that could be going towards investment? Many people, like you said, are flooded in debt, and so you could be listening to this episode, and saying, ‘What disposable income do I have? I’m just trying to survive. I’m trying to make it.’ But that’s really where we’re getting at is let’s just assume you’re going into this episode that you have money to invest to put in retirement accounts. Now, if that’s who you are listening to this episode and saying, I don’t have any money to put in investments because of the bills and things I have, well, it’s a pretty simple equation. That in order to increase your disposable income, you’ve got to increase your earnings, get a side hustle, work more hours, or you’ve got to decrease your expenses. And so that’s where really budgeting comes into play.

Tim Ulbrich: Absolutely, yeah. And I think that idea of it’s a simple equation — you either increase your earnings or you decrease your expenses. And just a shout out to the work you’ve been doing with the side hustle series, giving people ideas. We’ve got more content coming there. And just before we jump into the buckets of investing, I think it’s important that we are not — and we’ve had this conversation multiple times on the previous episodes — but we’re not going to have a conversation about should I be investing or should I be paying off my debt? And as I mentioned before, one of my concerns with an episode like this where we talk about investing or even the month-long series in a silo is that this is one part of a comprehensive financial plan. And you’ve got to look at the whole picture. So if you want more information on our thoughts about investing while in debt and how does that fit in with emergency funds and other life goals, head on over to episodes 068, where Tim Baker and I tackle that, where we reviewed the pros and cons of the Dave Ramsey plan. And I’m sure that’s evoked a lot of emotional reactions because it usually does.

Tim Church: Yeah, that was a great episode. And I think you guys did a great job talking through some of the controversy, but also some of the positive things that are in that plan and some of the behavioral aspects of it. And so when we’re talking about these major buckets, things that you can invest in for retirement, one of the things that came to mind, Tim Baker, he recently did an investing webinar. And he showed this image of actual buckets, and he was naming the buckets and putting one in. And I don’t know if when you were a kid, Tim — do you ever remember that show, Bozo the Clown? Do you ever remember that?

Tim Ulbrich: Yeah, yes.

Tim Church: And in that show, at the end of the episode — I think it was at the end — they actually were throwing ping pong balls into buckets. And they progressively — but there was a specific order that you had to put them in. And for some reason, he really evoked that memory when he was showing that figure. But it’s cool because it’s really, that’s what we’re talking about here. We’re talking about, OK, what’s the first bucket that you’re going to put your money toward? And then how do you go to the next level and what do you do?

Tim Ulbrich: And I think the visuals he used as well with the buckets in that presentation, it was a good reminder that these are vehicles and not the investments themselves. That’s an important point. We’ll talk more throughout this month. But when we talk about 401k’s, 403b’s, IRAs, etc., those are essentially the tax advantage shield in which you’re investing. But within that, you’re going to be choosing the individual investments, whether that’s stocks, bonds or mutual funds, etc. So let’s jump into these buckets. So probably for the vast majority of our listeners, they’re going to be presented by their employer with an option of a 401k, a 403b and what’s referred to as a TSP, which is a VA employee, right, that’s you.

Tim Church: Right, that’s the Thrift Savings Plan.

Tim Ulbrich: The Thrift Savings Plan. So we’re going to group these together because I think we throw around these words like we assume everyone understands exactly the implications of them. So let’s review quickly — a 401k, a 403b, and a Thrift Savings Plan, these are employer-sponsored retirement plans. So obviously, in order to get this benefit, you’re working for somebody. They’re going to offer this. And at what level they’re offering this benefit in terms of a match and what they can contribute is all over the place. And I think one of the things that we’ll talk in future episodes is as you’re looking at different jobs and comparing benefits and things, it’s a key thing to be looking at what is the benefit that you have? And I know the VA, that’s a pretty lucrative benefit on your TSP, is that correct?

Tim Church: Yeah, through the TSP — a couple different reasons. No. 1, they do offer a match up to 5%. But one of the other things is that they have very low fees in the funds that they have available. And I know that, Tim Baker always talks about that when you’re looking at different options within your 401k, is that you have to pay attention to those fees because even if you’re not seeing that change in your accounts, like over time, it can really eat at the earnings that you have.

Tim Ulbrich: Absolutely. And so let’s talk first — we’ve got 401k’s, 403b’s or TSPs, let’s talk about the traditional variety first because what has complicated this whole equation is that — you know, I remember when I came out of school, we were looking at primarily a traditional 401k or a Roth IRA. And now, we’ve got hybrids of these vehicles such as a Roth 401k or a Roth 403b, which I think has made this very complicated and probably make it even difficult to talk about it on the podcast in something like this. It’s good for a visual. So when we talk about a traditional 401k or 403b, essentially what we’re referring to there is that you are deferring the payment of taxes to the future. So those are a deductible in terms of income taxes today. You are not paying taxes on the contributions today. But when you go to withdraw those funds, no earlier than the age of 59.5 without penalty — and there’s a required minimum distribution at the age at which you’re beginning to have to force to take out that money — the maximum amount that you can put in as an employee into these accounts in $18,500 in the year of 2018. We’ve seen that climb each year by $500 or so. Now, there is an additional amount that you can put in after the age of 50. And that is $6,000, which essentially is a catch-up provision that allows you, if you’re behind in savings, to be able to save more beyond that $18,500. Now, what this does not include, which is a really critical, important piece here, is that $18,500 does not include the portion in which your employer would provide in the form of a match. Now, if you’re not familiar or haven’t heard of that term, match before, as Tim gave the example with the VA, it’s a 5% match. Essentially, 5% of his salary that he contributes, the VA will contribute dollar-for-dollar. And this is all over the place with employers. Some will do a 3% match, some will do a 6% match, some will do a dollar-for-dollar, some will do 50 cents on the dollar. But essentially as you’ll see when we get into the priority of investing, the match is free money. And that’s really the critical piece here. So why is this number important? Because what we’re referring to is that you obviously are growing money tax-free for a period of time. But ultimately, when it comes to being pulled out, you’re going to be paying taxes on that money. But if you make $100,000 — just out of simplicity — $100,000 per year, and you contribute $15,000 into your 401l, essentially you are going to be paying income taxes on $85,000. So it’s reducing your taxable income today. That money is growing all along, and you’re not going to pay taxes until the point you distribute it. And obviously depending on the income tax bracket you’re in and what the income tax bracket rates are at the time, you’re then going to be slapped with an income tax bill in the future.

Tim Church: Yeah, and I think that’s a good point to bring up is that when you’re looking at those account balances, somewhat really of an illusion when you’re looking at that bottom line if all of your contributions are traditional because it’s going to get taxed eventually, it’s just at what level is going to depend on where you are at the time when you’re making those withdrawals. Versus the Roth version — so many employers now offer the Roth version, and that’s even for the Thrift Savings Plan, where basically, you’re going to make contributions after-tax. So you’ve already been taxed on your income, and you’re going to allow those contributions to grow tax-free. So when I say tax-free, it basically is at the time at which you’re eligible to make the withdrawals, you’re not going to be taxed on that money. Now, that’s a whole separate animal in terms of determining what is best for you. Should you do traditional contributions? Should you do Roth contributions? And there’s a lot of different factors that can play into that, such as what your projected tax bracket’s going to be at the time of retirement or eligibility. And that could be a couple different things there. Does the government change the tax brackets? But then also, what is your projected income going to be? And things could obviously change with your job, so it’s really sort of difficult to predict everything. But there are some simulations out there online where you can kind of go through that.

Tim Ulbrich: And I think your point earlier about considering the tax implications is so critical to retirement planning because we often — and we’ve talked before on the podcast about a nest egg, how much you need at the point of retirement. Well, that number, if a majority of that’s in a traditional 401k, for somebody else that’s maybe saved a lot in a Roth IRA, which I’m going to talk about here in a minute, how that’s going to play out when you’re in retirement is very different in terms of the total amount that you have and how it’s going to be taxed. So I say that because I think the tax implications are a key planning piece as you’re thinking about exactly how much do I need at the point of retirement, and what’s going to be taxed? And what’s not going to be taxed when you get to the point of withdrawal? So again, 401k, 403b, TSP, max contributions in 2018 are $18,500 for the majority of people that will be listening to this podcast. And that number I think will be important because you often hear people say generally, to meet your retirement goals, you’re probably looking at somewhere around maybe 15-20% of your income that needs to be saved. So if you figure out the numbers, a pharmacist making $120,000, obviously you’re starting to get that point with the 401k, 403b, but there’s other vehicles that we’re going to talk through right now. And let’s go to that next one, which is an IRA. So Tim Church, IRA, Individual Retirement Arrangement, this one has different figures, different numbers, but also has a traditional form of it as well as a Roth form of it. So talk us through that one.

Tim Church: Correct. So this is something that anybody with an earned income is eligible for. They can contribute up to the max, which as of 2018 is $5,500. And there’s an extra $1,000 if you’re 50 or olders, so $6,500 if you’re 50 or older. But anyone who is earning an income can contribute to this. And what’s important is this is something outside of your employer. So this is something that you set up on your own, either through a brokerage account — but the other thing here too is besides what you’re able to contribute, if you’re a married and you have a non-working spouse, they can also contribute up to that limit. So technically, if you’re less than age 50, your household if you’re working and you have a non-working spouse, you can contribute up to $11,000 per year.

Tim Ulbrich: Yeah, and I think that’s an important provision. I know for Jess and I, so Jess is at home with the boys, she’s not working. But to your point, a non-working spouse, so for us, when we talk about a Roth IRA, we both contribute that $5,500 per year to be able to make that contribution. So this has both a traditional version as well as a Roth version. And again, I think that’s where it gets confusing when people hear Roth 401k, Roth IRA. So traditional IRA looks very much — obviously the numbers are different, the $5,500 per year — but looks very much tax-wise like a 401k or 403b in that you are — if you meet the income qualifications — you are deferring the payment of taxes to a later point in time. You know, many pharmacists don’t qualify in terms of the income limits for a traditional IRA.

Tim Church: Right. And if you look at the IRS has some different rules depending on whether you are covered by a 401k or whether you’re not covered by a 401k. But if you are, the phase-out if you’re single is $73,000. And for being married filing jointly, it’s $121,000. So if you make above those limits, you actually can’t deduct the traditional IRA contributions. And so that kind of leads into well then why would I ever do that, right?

Tim Ulbrich: Absolutely, yeah. And I think that we’ll talk in a minute about the back-door Roth IRA, and we’re going to actually in our upcoming Q&A episode even talk a little bit more about it. But when we talk about a Roth IRA, and I think why Roth IRA’s have all the rage these days, rightfully so, is that you are paying taxes today, that money is growing, but you are never paying taxes on that money again in the future. So if I were to contribute up to the max, $5,500 per year in a Roth IRA, and Jess did the same, that’s money that is being contributed that we’ve already paid our taxes on. So got my paycheck, paid taxes, then I make the contribution into the Roth IRA. I invest that money, it grows at some percentage every year, hopefully that compounds, let’s say that turns into a half million dollars, I’m at the age of 70, I start to withdraw that money, I’m no longer paying taxes on that money because I already paid taxes on the money before I put it into the account. Now, this gets into the whole debate about, well, would I be better off putting money in a Roth IRA or a 401k, and that gets back to the point that Tim Church made in terms of the tax brackets and what’s going to happen in the future, and largely, I think most people would agree we probably don’t know at this point in time. Now, this also has income limits to directly contribute. So for those that are single, the phase-out of contributions at $135,000. For those that are married filing jointly, there’s a phase-out that’s at $199,000. And so this is where you’ll hear people and you’ll hear pharmacists say, ‘Well, I really like that idea of tax-free growth, I pay taxes now, I’m not going to pay taxes in the future. But I exceed that income limit,’ and insert the back-door Roth IRA. Now, we could have a whole separate episode probably about the back-door Roth IRA. There’s some great tutorials, resources online. I know the White Coat Investor — just shout out to what he’s done — he’s got some great tools and resources about how people can go through that process. But essentially, what you’re doing in a back-door Roth IRA is you’re contributing to a traditional IRA, and then you’re converting that to a Roth component. And so we’re going to come back to that in our Investing Q&A. But all that to say if you’re somebody that exceeds the income limits of a Roth IRA, that does not mean you cannot take advantage of the benefits of a Roth IRA because of that back-door components.

Tim Church: Right. And I think the key is to keep in mind that it really is about the timeframe at which you make that conversion and whether there’s any gains on the money when you make the contributions to a traditional IRA. So if there’s any gains in between that conversion, you’re going to pay taxes on it. The other thing is too is that if you’ve already had past traditional IRAs, and you didn’t convert them, there can be some tax implications with that as well.

Tim Ulbrich: You know, the other thing I love about Roths, which I don’t think is talked about enough is that they do not have the forced required minimum distribution that come with the 401k or 403b. So if somebody’s out there thinking, you know what, maybe I’m going to be working until I’m 75 or 80 or maybe I have other sources of wealth, real estate investing, businesses, whatever, and you think you may not need that money at the required minimum distribution age in the early 70s that you’d be forced to take in a 401k or 403b, to me, that’s one of the great advantages of a Roth IRA, that you continue to let that money grow, and you don’t have to take it out. Alright, we’ve got another big bucket here, Tim, in terms of the HSA or the Health Savings Accounts, which we talked about in Episode 019 in details for those that want to go back and look at those. But give us the down-low on HSAs. I know you have this benefit through the VA, but this has the lethal triple-tax benefits, which are talked about often. So why are HSAs so powerful?

Tim Church: Well, exactly just like you said. It has the triple tax benefit. But yeah, this is one of the cool things that I started for my wife and I for this year for 2018 because I didn’t really know much about it before and what the implications were. But just going through as we talked about through YFP, I mean, it really has a lot of power. And the name itself is really a misnomer because you look at that and you say, Health Savings Account, so it’s just a regular savings account that I can use to pay health expenses, right? Well, not exactly. It can actually be an investment vehicle. It’s really an investment account in disguise. It really depends on your intentions or how you’re going to use it. And for some of these accounts, you have to have a certain amount before you can unlock those investment options. So for example, for me, is I had to have $2,000 in the account before I was allowed to contribute anything towards an actual investment.

Tim Ulbrich: Does that vary by who offers the accounts?

Tim Church: Yeah, I think it does. I don’t believe that that is an IRS stipulation. I think it does depend on the bank that is servicing the HSA.

Tim Ulbrich: I thought I saw that on the Facebook group, people were talking about, well, ‘with my employer, that number is different,’ so yeah.

Tim Church: Right. So like we were talking about is, how you’re going to manage this account really depends on that intention. So you could be using this account to strictly pay for medical expenses, and the benefit of doing that is you’d be paying for them pre-tax, which is not a bad thing. I mean, that’s a great way if you have anticipated medical expenses and you want to be able to pay for them with some tax efficiency, then that’s great. But you can also look at this from the perspective as I’m going to use my HSA as an investment vehicle. So you’re going to say, I’m going to pay for all of my medical expenses out-of-pocket, and I’m just going to invest the rest, and I’m going to treat it like an IRA or I’m going to treat it like my 401k in that my goal is to beat inflation to actually get some compound growth.

Tim Ulbrich: And is the thought here if you’re going to pay for your medical expenses out-of-pocket now and really let that grow, it sounds like it’s got the benefits of a Roth IRA plus you’re not paying taxes now. It’s got that, you know, the highs of the 401k, 403b and also the highs of the IRA. But at some point, are you forced to use those on medical expenses?

Tim Church: No, so it’s really kind of interesting about the account. So just to jump into that triple tax benefit. So the first one is that it will lower your adjusted gross income. So you can — any contributions you’re making to the account are tax-deductible.

Tim Ulbrich: Like a 401k and 403b.

Tim Church: Correct — if they’re traditional, correct.

Tim Ulbrich: Yep.

Tim Church: And then that account, any contribution that you put in are going to grow tax-free. Now, the withdrawals are tax-free as long as you can prove that they’re being used to pay for a qualified medical expense because otherwise, you’re going to pay a 20% tax if you take the money out before age 65 for a non-qualified expense. Now, if it’s after age 65, to my knowledge, there’s no additional penalty, there’s no additional tax. You basically, it’s like a regular retirement account. Now, here’s the caveat. So — and this is one thing that I didn’t know until I really got into it is that let’s say you contribute to an HSA over 20-30 years. And those accounts are growing, you’ve been investing them aggressively, and you’ve got some great growth on them. And let’s say you’re 60. Can you pull out some of that growth that you’ve had, some of that money that’s in there, but without paying taxes on it? And you can because the caveat is that if you keep track of all of your medical expenses you paid over that time that you’ve been contributing and can prove that you’re essentially reimbursing yourself, you’re not going to have to pay those taxes. But the key is really, you have to keep a good record of those receipts. What I’ve been doing is basically putting anything I have into the cloud, into Google Drive, and doing that for every year so I know exactly what I’ve paid and what I can technically claim as being a reimbursable expense.

Tim Ulbrich: Sounds like you need to develop like an HSA tracking expense app.

Tim Church: Yeah, there’s probably something out there.

Tim Ulbrich: Maybe it’s the next business project. But so unfortunately, not everybody has these available. But for those that do — and we’ll get into this prioritization — you often hear people putting these at the level of, OK, take your match, and then you think about an HSA. We’ll come back to that, but the reason that is and why they are so highly regarded in terms of priority investing is because of the tax benefits that you were just talking about. But not everybody qualifies. I know I haven’t with the employers I’ve worked with. In the state benefits, we didn’t have what was considered a high-deductible health plan. So to qualify, you have to be enrolled in a high-deductible health plan. What basically is a high-deductible health plan? Well, this year, for an individual, it’s having a plan with a deductible of at least $1,350. And for a family, that deductible is at least $2,700. Now, I think what we’ve seen with health insurance benefits pushing some of the costs back into the consumer and obviously increasing deductibles, we’ve seen more people being eligible for these. And I think it’s a great time to talk about this because of the time period around open enrollment. So if you’re somebody saying, do I have a high-deductible health plan? Do I not? Does my employer offer an HSA or not? Now is the time to look to see where this may fit in the context of your prioritization of investing.

Tim Church: And I would say that the two major reasons that my wife and I, we decided to switch from a traditional PPO health plan to a high-deductible health plan, really for the opportunity to contribute to the HSA but also the other benefit is that high-deductible health plans typically have lower premiums. So with the old plan, I was paying a lot more each month, but I wasn’t using any of the insurance that I was paying for. So if you’re relatively healthy, I think it’s a great option. So if stuff comes up, you might be paying some money out-of-pocket, but again, you wouldn’t have had that option otherwise to even contribute to an HSA. And you have to really look in the context of what your premiums are.

Tim Ulbrich: That’s a great point. And I think what you just said too speaks to the power of the emergency fund and having an emergency fund because if you can afford to take on that risk of, you know, maybe I’m healthy now, something comes up unexpectedly, I get slapped with a huge payment. Then ultimately, you’re ready to take that on, and you can afford it without feeling that risk of that. So what we didn’t talk about here with HSAs is the max contribution amount. So we talked about it with 401k’s and 403b’s or the TSPs, we’re looking at $18,500. We talked about with the IRAs, $5,500. What about the HSAs?

Tim Church: So as of 2018, if you’re single, it’s $3,450. And then if you’re self plus one or family, it’s $6,900. And an additional $1,000 if you’re 55 or older for catch-up. And this — just like the other accounts — this typically changes every year, every couple years.

Tim Ulbrich: So what I like, if you start to string these together between a 401k, a 403b, a Roth IRA or a traditional IRA, if you qualify as well as if you have access to an HSA, you can start to get to a point where you’re saving a significant percentage of your salary, probably more than many listening, especially in the contest of other goals. But nonetheless, you have the option to be saving a significant portion of your salary that has tax advantages. And I think that’s key because one of the last things that we want to talk about here is the taxable or brokerage accounts. And so with the taxable brokerage accounts, why I said that previous point I think is important is that I see a lot of new graduates getting ads and promotions for some of these apps and tools and things that are out there. But they’re investing outside of the tax-advantaged accounts. And so I think as we talk about taxable or brokerage account, where we see this fit in is once you’ve exhausted all your other tax-favored retirement plans, this probably is the final option that you’re looking at because of the loss of tax-shield capital gains taxes that you have to pay, etc. So good news here is if you get to the point where you max out everything and you’re looking for options, there’s lots of options out there in which you can invest. But don’t get too far ahead of yourself if you’re not taking advantage of the match or other tax advantages that we’ve talked about previously. So last one quickly before we talk about prioritization of these buckets would be the SEP IRA. And I think this is timely because of your side hustle series. And so maybe we have people out there that own their own business, are starting their own business, want to, and to me, when I see information about a SEP IRA, that makes me want to start some businesses because you’ve got some really good advantages with retirement options. So what is a SEP IRA? And what flexibility and freedom does it give you in terms of retirement?

Tim Church: So a SEP IRA stands for a Simplified Employee Pension. And basically, if you’re self-employed, you own your business, you have this opportunity, this benefit available to you. And this could be in addition to a 401k that you have available. So this could be something that you’re doing on the side, an additional business you own. But one of the advantages is that there’s a lot more money you could potentially contribute versus what’s available with a 401k or IRA. I mean, it’s a huge difference. But obviously, you have to be making that much money up to that certain point to be able to. So right now, what the guidelines are, is that you can contribute up to the lesser amount of either 25% of your compensation or $55,000. But when I see those kind of numbers — like you’re shaking your head here, Tim — that just gets people fired up, I think, to say, hey, what if I was able to bring in an additional amount of income that I’m no longer capped out at this 401k, this IRA max that’s there.

Tim Ulbrich: Yeah, reason No. 403 to start a side hustle, right? I mean, when you see those numbers, and it gets me fired up even for the work that we’re doing that to your point, it’s dependent on compensation, obviously, you mentioned the lesser of those numbers. But in addition to other retirement vehicles, you can obviously make some great headway if you’re in a position to do that. OK, let’s jump in now. We’ve set the stage, we’ve spent a decent amount of time talking about the buckets, which is important because before we can talk about prioritization, we have to know what we’re talking about. What is a 401k? What is a 403b? What is a Roth? Now, a couple disclaimers here that I think we have to talk about because we’re probably going to take some flack regardless, which is OK. But not everyone is going to agree with the prioritization that we’re talking about. Not necessarily that there is one right way in terms of order of investing. Now, we’re going to give a framework on that that we think many listening will follow, but to my point earlier, everybody has different personal situations in terms of income earned, in terms of other financial priorities, in terms of other goals, when you want to retire, all types of variables that may come into play in terms of how you actually execute this.

Tim Church: Yeah, and I think like there’s a lot of people out there that are really into real estate, and they look at that as even taking priority over some of these retirement accounts because either they’re all-in or they’re confident that they’re going to get good returns there. And I think that’s great. I think for some people, that is an awesome option. But I think here, like you said, we’re talking in the context of, OK, let’s focusing in on these retirement accounts and just really try to figure out, well, what is the best order?

Tim Ulbrich: Yeah, and I think the other situation I think about, Tim, is those that are on fire about the FIRE moment, the Financial Independence Retire Early, waiting until 59.5 to access your accounts may not be the goal they’re after. And so you know, obviously again, this to me really speaks to the power of sitting down with somebody like Tim Baker and financial planning and talking about what are your goals and then putting out a map to be able to achieve those. The last thing I have to say here as a disclaimer before we jump into the prioritization — if Tim Baker was here, he would make me say this — is what we are saying is not financial advice, right? So we don’t know of the thousands of you listening, we don’t know what your own personal situation is. So we’re looking, again, down the lane of investing. If you have disposable income to invest, this is the priority we think you should consider. But we’re not saying, run out and do this tonight. You’ve got to think about the context of the plan. OK, No. 1 — I think everyone agrees with this. I mean, maybe there’s a person or two out there, maybe? I don’t know.

Tim Church: I haven’t seen — so what I was looking at to see what else is on the Internet and some of the other bloggers, I think this is one thing almost everybody I think actually agrees on.

Tim Ulbrich: For how much disagreement there is.

Tim Church: Right.

Tim Ulbrich: So No. 1, as you may have guessed it, is the employer match, right? No surprises here, most people agree on this. You are getting free money from your employer. If you don’t take it, you’re leaving it on the table. And so we even believe, we talked about this in the Dave Ramsey episode, Episode 068, the match has to be a priority in your financial plan, even in the context, I think, of student loan debt — maybe a different conversation depending on personal situations, but you have to take that money. Now, for you, you mentioned that 5% match. So let’s just use a hypothetical. Somebody’s making $100,000, they put in 5%, they get 5%, that’s $10,000 of tax-deductible retirement savings that are going to grow over time. You’re putting in 5, your employer’s putting in 5. And again, as I mentioned earlier, you’ll see this in different situations in terms of the percentage of salary match. It may be 5%, 6%, 3%, no percent, dollar-for-dollar, $.50-per-dollar. And so it’s all over the place.

Tim Church: Or what you get. What have you gotten at schools? You’ve gotten like 14%?

Tim Ulbrich: Well, I’m unemployed right now.

Tim Church: Oh, OK.

Tim Ulbrich: But you know, yeah. So you know, I’m lucky to work in the state teachers’ retirement system, which we actually are forced to put in. I remember when I was in the grinding out of paying off debt, it was painful. But we are forced to put in 14%, and there’s some fees and things that shakes out to that they match around 10%. So it’s kind of a forced combined contribution of about 24% total, which is really nice. But the downside is I actually don’t get any Social Security, so I won’t receive that Social Security benefit in the future if it’s there. But we’ll see. So No. 1, employer match. Now, No. 2 is HSAs or Health Savings Accounts. Take the employer match, and I think what often, people do right after the employer match is they just go up and maybe max out their 401k. I think what you’re making a point here is maybe after that match, move into the HSA if you have it available.

Tim Church: Yeah, and I think — but even going back to is that a bad option of putting more money in your 401k? So I think like in the context, which is interesting here is that really, even if you’re switching up the order on some of these, like really, it’s still not a bad decision. The decision to actually put money into the accounts to grow is a good thing. But I do think, you know, the HSA with that triple tax benefit, it’s hard to argue against that, right?

Tim Ulbrich: Absolutely.

Tim Church: I mean, it’s such a powerful tool. I think Dr. James Daly of the White Coat Investor, he calls it the Stealth IRA, which is pretty cool.

Tim Ulbrich: I love it.

Tim Church: Because it’s basically like you’re getting the opportunity to contribute to another IRA if that’s your intention behind it. But it can really be a powerful way to get some additional retirement savings.

Tim Ulbrich: I do have HSA envy. I don’t have access to an HSA, so unfortunately, yes, great match, but I wish I had that HSA option. So No. 1, we said employer match. No 2, HSA triple tax benefit makes a whole lot of sense.

Tim Church: If available, right? Because not everybody’s going to have that.

Tim Ulbrich: Right. High-deductible health plan, you may or may not have it. Now, No. 3 here, we’re getting into the IRA. And really what we’re getting at is the Roth IRA component. And obviously, for those that don’t meet those income qualifications, they would have to do a back-door Roth IRA. But what we really want to take advantage here is the tax-free savings that are going to happen over time. You’re paying taxes today, you put the money in, it grows tax-free, you go to pull it out, you’re not paying taxes anymore. So even though this doesn’t have the same maximum as the 401k, 403b’s, you’re not going to be able to have these be equally weighted, pre- and post-tax, right? $18,500, $5,500. To me, I see this as the way that you’re balancing out getting to the point of retirement, you’ve got some free and post-tax savings. So if I’m maxing a Roth IRA at $5,500 per year or back-door Roth IRA to get there, and then I’m putting in $18,500 in a 401k or 403b, of course I’m going to have more in accounts that are going to get taxed than I am in accounts that are not going to get taxed. But I’m balancing those out a little bit.

Tim Church: It also depends too if you have a Roth 401k, then also that could be after-tax contributions, so it’s possible you could have both. You could do the Roth IRA and a Roth 401k and basically putting everything in after taxes and then letting your accounts grow tax-free. I think going back to what we talked about is that since most pharmacists are not going to get the deduction if they contribute to a traditional IRA, it sort of makes sense to always go to the back-door Roth. Well, I think one of the interesting questions — and this has come up before — is why would I not just go up higher on my 401k versus contributing to an IRA? And really, you know, the way I look at that is either one is still a great option in terms of the contributions. The difference, really, is that with the IRA, this is outside of your employer, which means a lot more options.

Tim Ulbrich: Yeah. And that’s why you hear — we won’t get into it here — but that’s why you hear when you switch employers, there’s value in rolling that over into an IRA where you can unlock those options. And one of the things I’ve seen with Tim Baker’s help is the variety of what people have available to them in an employer-sponsored 401k or 403b, both options and fees, good or bad, is all over the place. Some have very limited options, very high fees, and maybe their employer doesn’t even really recognize or acknowledge the value. Others are maybe working with a Fidelity, Vanguard, whomever, have tons of options, can get low-fee accounts. So this really is an individualized decision.

Tim Church: I totally agree because when I look at the Thrift Savings Plan, one of the benefits of a Thrift Savings Plan, like we talked about earlier, is there’s such low fees on that. And so with a situation like that, I mean, you could make the argument that either one is going to be fine. But if I’ve got really low-fee options that are getting great growth, then I may go and try to max out my 401k or increase prior to going to the IRA.

Tim Ulbrich: And I think your point is a good one. At the end of the day, we’re splitting hairs, right? If you’re having this debate, there’s lots of opinions, lots of nuances, but at the end of the day, you’re doing a good job, you’re being intentional, you’re saving for the future. I tend to favor the prioritization of really maxing out the Roth component before I go back to max out the traditional 401k because of what I mentioned earlier and having that balance of pre- and post-tax, but again, people have different answers on that based on what they think is going to happen in terms of the tax component. So just going back in order here — your employer match, HSA, IRA component, we talked specifically about the Roth component of an IRA or a Roth 401k, right? And then going back to your traditional 401k, maxing that out to the $18,500. Now, if you get to this point, and you’ve taken an employer match, you’ve maxed out an HSA if you have it, you’ve maxed out the IRA, and you’ve maxed out your 401k, you’re crushing it.

Tim Church: Yeah, I mean, that’s pretty awesome. I mean, I’m not quite there yet. But it really is encouraging to see those numbers as a goal, really, to say, hey that’s where I want to be.

Tim Ulbrich: When you put those numbers together, we’re talking about $18,500, another few thousand, another $5,000 — you’re saving a significant percentage of your salary, looking at several million dollars with compound growth over 30-40 years. Now, after we max out the 401k or the 403b or the TSP, then obviously, if people have access to a SEP IRA, they’re going to take advantage of that. Now, after Step 5 here…

Tim Church: Right, that would depend if they have some kind of additional income or potentially they don’t work as a W2 employee, and their main business or their main job is as an employer or a small business. So that actually could be somewhat reversed depending on the situation and depending on what kind of job you have.

Tim Ulbrich: What you have available, yes. I think what we’re doing here is — before we get to the last one, which we’re calling them brokerage accounts, which as I made the point earlier, these don’t have the same tax advantages that all these others do. So what we’re advocating for is really maxing out the opportunities you have to save in tax-advantaged vehicles and then ultimately if you’re still looking to save more, personally I’d probably advocate for maybe some real estate investing, some business stuff, other things before even brokerage accounts. But you’ve got lots of options available.

Tim Church: You’ve got lots of options. And the other thing too is as long as you’re not continually trading fees and different things like that, I mean, capital gains tax is actually still tax efficient versus some other things that are out there that you’re going to get taxed ordinary income.
Tim Ulbrich: Absolutely. Fun stuff. We covered a lot here, packed full of information. I think this is one we’re going to hopefully go back and say, ‘Hey, you got questions about the different investing buckets, prioritization, go back to Episode 073, we’ve got some great information.’ And this is a reminder, for those of you that haven’t yet done so, if you could leave us a review in iTunes, if you like what you heard, or whatever podcast player that you’re listening to, we would greatly appreciate it. Also, if you haven’t yet done so, make sure to head on over to YourFinancialPharmacist.com, where we’ve got lots of resources, guides, calculators, that are intended to help you as the pharmacy professional on your path towards achieving financial freedom. Tim Church, this has been fun and looking forward to coming back and finishing up the series.

Tim Church: It’s been great, Tim.

Sponsor: Before we wrap up today’s episode of the Your Financial Pharmacist podcast, I want to again thank our sponsor, PolicyGenius. Now, you’ve heard us talk many times before on the show about the importance of having a solid life insurance plan in place. And while we know that life insurance isn’t the most exciting or enjoyable thing to think about, actually having a life insurance policy in place is a really good feeling. And PolicyGenius is an easy way to get life insurance online. In just two minutes, you can compare quotes from the top insurers to find the best policy for you. And we know that when you compare quotes, you save money. It’s really that simple. So if you’ve been avoiding getting life insurance because it’s difficult or confusing, give PolicyGenius a try. Just go to PolicyGenius.com, get your quote, and apply in minutes. You can do the whole thing on your phone right now. PolicyGenius, the easy way to compare and buy life insurance.

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YFP 072: Investing Mind Tricks: How Behavioral Bias Affects Our Decisions

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How Behavioral Bias Affects Our Decisions

On Episode 72 of the Your Financial Pharmacist Podcast, Tim Church, YFP Team Member, and Tim Baker, YFP Team Member and Founder of Script Financial, discuss how behavioral bias can impact investing decisions and why they are so important to have on your radar.

Summary

Tim and Tim talk through 6 major behavioral and financial biases that have an impact on making investment decisions.

  1. Overconfidence bias refers to our subjective belief in our skills. Our ability to invest is typically greater than the actual objective reasoning behind it leading us to think that we have control in the stock market. An example of this can be seen in the 2006 study by James Montier, Behaving Badly, in which 74% of fund managers believed they delivered an above average job performance and the remaining 26% believed they delivered an average job performance. This shows an irrational high level of confidence. It’s also important to note that timing the market is impossible as you don’t know where the market is going to go.
  2. Confirmation or Hindsight bias shows that people pay more attention to information that supports preconceived ideas about a subject and they ignore or rationalize a way to the rest. The hindsight bias shows that passed events were predictable and completely obvious.
  3. Loss aversion is where people value the gains and losses differently. Losses have more of an emotional impact on us and we act irrationally to avoid loss and it’s one of the biggest reasons people don’t invest.
  4. Herd mentality means an individual conforms to the behavior of a larger group and is typically based on emotion. An example of this can be seen with Bitcoin or the .com crisis. It also happens inside mutual funds due to the actions of share owners.
  5. Hyperbolic discounting, or present bias, shows that we have a tendency to prefer rewards today that may be smaller or similar and give up on something greater in the future. This bias is the main reason why people don’t contribute enough to their retirement funds and discount the future reward.
  6. Overreaction bias is when new information is reflected instantly and investors overreact and create larger than appropriate affect on the stock market.

Mentioned on the Show

Episode Transcript

Tim Church: What’s up, everybody? And welcome to Episode 072. I’m here with Tim Baker and excited to dive into today’s topic. Tim, this is something you and I have talked about many times and really appreciate the impact it has on our financial decisions. Behavioral bias related to investing has been studied a lot under the umbrella of behavioral finance. And Tim, why is this something that people really should know about?

Tim Baker: Yeah, Tim, I think it really can be summed up in three words. People are irrational. So we often think that a lot of our economic theory is based on the premise that we act as participants, as humans, as rational beings when it comes to the money and really economic theory. But oftentimes, the opposite is true. And really, some of the biases we’re going to talk about today illustrate that point, and hopefully we can get some examples out there to kind of paint the picture. But yeah, I think this is one of the things, one of the topics that really fascinates me because obviously I can see myself in a lot of these things, and I can see my clients in a lot of these biases. And you kind of shake your head, well, why do we do that? Why do we behave this way when the probabilities really aren’t different? Or whatever the case is. And I think it’s really — we have to shine a light on it to make ourselves better when it comes to not just investing, but just behavioral finance in general.

Tim Church: Yeah, I think what’s interesting is that you and I have talked about that even though we’re aware of these biases going on and how they influence our decisions, that still, we’re able to make the same mistakes based on how they play out. And so that’s what’s really tough is that even though you know about them, they still can happen. But I do think it plays so much into our day-to-day decision-making and really can have a huge impact not only today but just on your long-term outlook of your financial plan, your financial health in general. So we’re going to go through a couple of these biases and kind of talk about what they are and really kind of to focus on how they impact investment decisions. Now, they can impact other parts of the financial plan, but really, we want to focus on in terms of investments, how that happens. So let’s start out with the first one, overconfidence. So as pharmacists, we’re pretty confident because of the training and things that we have and how we make our clinical decisions. And most pharmacists that I’ve met in my career, they’re very confident in how they practice and what they do. And a lot of times that we see this actually tip into investment and personal finance — and it kind of goes back that just because you’re confident and you’re knowledgeable in one area doesn’t always mean that that’s going to be the case for finances. But Tim, talk a little bit about how overconfidence impacts investment decisions.

Tim Baker: Yeah, so overconfidence I think fits under the miscalibration bias. So you know, basically, the overconfidence bias states that subjective belief in our skills and our ability to, say, invest is typically greater than the actual objective reason behind that. So sometimes, we view that we have this illusion of control when it comes to investment. And I see this sometimes with clients today where with the markets really doing well — and I actually had a client recently reach out to me, saying, ‘Hey, I’ve been licking my wounds from the recent downturn in the market.’ And I think he’s probably suffering from a little overconfidence that you can have this illusion of control that you can control, really, the uncontrollable. And the uncontrollable really is the stock market. There are so many things that go into where the price of the market or of individual security goes that you as the investor play little role in that. But it’s interesting to kind of outline this study that was done in 2006. It’s called — a landmark study called “Behaving Badly.” And the researcher, James Montier — I believe is how he pronounces his name — basically surveyed a bunch of professional fund managers. These are the individuals that sit on top of the mutual funds and basically buy and sell investments out of that fund. And when he surveyed 300 of these professionals, he found that 74% of them believe that they had delivered above average job performance. And really, the remain 26% believed that they were at least average. So essentially, that means that 100% of those 300 surveyed believes that they are either average or above average when it comes to basically managing their mutual fund. And of course, we all know that in statistics, that can’t be the case. We have a bell curve that basically has distribution of where everyone falls. But the discrepancies really stress that many of these fund managers displayed an irrationally high level of confidence. And I would, when I saw this, when I was at West Point and even some employers since that, we had a grade essentially on a forced distribution that you’re always going to have people that are exceptional, average and then below average. So it’s the same that holds true is that for many investors, especially in this type of market, Tim, that we say, hey, I’m really killing it here. I’m doing a great job with my portfolio, I have this idea of the hot-hand falacy where I can’t lose. And you know, over time, it can be very humbling if you are in this space of being overconfident with your investments. And really, it’s an illusion of that you can actually control where the market goes because, really, you can’t.

Tim Church: So a lot of this with this bias, Tim, would — basically timing the market would fall under this bias. Is that correct?

Tim Baker: Yeah, absolutely. So there will be some people that — and I’ll give you an example, Tim. Like I had a lot of people after the last election say, hey, where do you think the market’s going to go? And I’m like, to me, my gut was that the market was going to go down for whatever reason. And I would have been wrong. So if I was trying to time it then, I would have been severely off. So again, I think what I know, I think the truism that I know about investment is that I don’t know where the market’s going to go. And I think any advisor, really investor, that tells you otherwise is lying to himself or herself. So you know, it’s the timing — you might get it right once or twice, you might read that story in the Wall Street Journal and make that investment, and it turns out right for you, but I think over time, what studies have shown is that you can’t time the market. And I think getting it right on an occasion or two leads to that overconfidence. And it’s the same thing with the fundamental analysis. You might analyze a stock and say, hey, I think this is a great buy opportunity and you buy it, and you’re right. And I think it kind of balloons your confidence a little bit. But I think more often than not, the house wins, in a sense — that the market is going to do what the market does. And really, your ability to assess and market time are going to be a distant second.

Tim Church: So basically, to heed the advice of Matthew McConaughey in “The Wolf of Wall Street,” right?

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Tim Baker: Yeah, we don’t know if you’re Warren Buffett or Jimmy Buffett, if the stock is going to go up, down, left, right or in circles. So yeah, it’s true. I think it’s one of the things that I think people sometimes come to advisors on this and say, hey, beat the market. But more often than not, that’s not what an advisor should be doing or can do. So yeah, I think maybe one of the secrets of the financial planning industry is that that really shouldn’t be the reason why you are hiring someone.

Tim Church: So the second bias that we want to talk about is confirmation bias and also hindsight bias also kind of plays into that. So talk a little bit about what that one is.

Tim Baker: Yeah, so as humans, what we do is we often introduce bias when we process information, when we process events. So you know, if we break down confirmation bias, it’s typically that people pay more attention to information that supports preconceived ideas about a subject, and they basically ignore or rationalize away the rest. So one of the confirmation biases, Tim, that we probably have as a community is that we believe that passive indexing is the proper way to build an asset allocation that is low-cost and typically that’s best for the investor. Now, if I’m reading studies or I’m reading information that confirms my thesis, my belief, then I highlight those, and those carry a lot more weight as I’m reading. And then when I’m reading maybe in the same session, I’m reading something that says, “Active investment is the way to go, and you get what you pay for in terms of the investment, so you pay a little bit higher in terms of the expense ratios.” So when I read that, my bias is to kind of like, I don’t think so, I basically rationalize that away. Or I’m ignoring it and say, thanks but no thanks. So I’m not buying that. So what confirmation bias is it kind of closes my mind in the sense that I’m discounting away the counterpoint to the information. And then sometimes, that can be dangerous. So the other bias that we look at hindsight bias, and this typically occurs when people believe after the fact that past events were predictable or completely obvious. And in fact, the event couldn’t be predicted reasonably. So many events seem obvious in hindsight. So I kind of look at this as like the Monday morning quarterback where something happens and you’re like, of course that happened. These are all the things that basically led to that event. But in the moment, really, we couldn’t have predicted that. So one thing when it comes to the investing and the stock market, it’s really the subprime mortgage prices and how all of the lending standards and kind of loose actions of the bank really led to the collapse of that part of the investment world and then obviously led to the Great Recession.
Tim Church: Yeah, and that sounds very similar to overconfidence because it kind of goes back to thinking that we were really able to predict that. Even though we didn’t say it at the time, but we really felt like yeah, we knew that. So one of my favorite behavioral biases is loss aversion. And that kind of falls under this umbrella of something called prospect theory, but it’s basically where people value gains and losses differently. And really, losses have more of an emotional impact, and so we’re less likely — we do whatever we can to avoid losses. And even though we could lose some amount or gain the same amount, we would rather gain than lose, basically.

Tim Baker: Yeah, and basically, Tim, what we’re saying here is that we act irrationally just to avoid loss. So that’s essentially — and I love the quote from — if you guys have ever seen “Rounders” out there, Matthew Damon’s character, who’s a poker player, he basically says that few players recall big pots that they have won, strange as it seems. But every player can remember with remarkable accuracy the outstanding tough beats of his career. So what this means is that we, the bad beats or the losses that we take with our investments, we feel that much more than, hey, the market has been en fuego that past seven or eight years. So the example is, would you rather receive $50? So I have $50 in my pocket, and I’m good to go. Or would you rather receive $100 and then lose $50 for some reason or the other? In both instances, the net gain is $50, so I’m still walking away in both of those situations with $50, but I’m like, ah, well I had $50 more, and now I don’t have it, and that kind of stinks. And that’s kind of what we’re talking about in a very granual way. I think the status quo bias, Tim, that you talk about sometimes is really not leaving your perch, kind of where you are, because of the fact that there is choice overload or there’s the fear of maybe the unknown or fear of if I make a move, I could lose. And this is typically where you are leaving retirement savings and that default asset allocation or default contribution — we talk about the 401k inertia that I know I need to get the match, which is at 5%. But I really don’t want to do any more than that because I’m comfortable with the status quo, and I don’t really want anything to change. So the loss aversion theory, which is kind of sometimes called prospect theory, is fundamental to us as humans. And it’s not just with just investment or money. It’s just how we will shell ourselves and protect ourselves from losses, even if it’s irrational or if the probabilities tell us otherwise.

Tim Church: Yeah, and I think that this is one of the biggest reasons why people will say, I’m not investing in the stock market. I’m not going to go in and lose all of my money because of things that have occurred previously. But mainly, it’s that I don’t want to lose money, so a lot of people will justify and say, I’m going to keep it in a savings account or something that is barely probably not even beating inflation. And so that right there can play a huge impact just in that decision itself.

Tim Baker: Yeah, exactly right. And often to the detriment of just your overall financial picture.

Tim Church: So the next one we want to talk about is herd mentality. And this is an interesting one because it basically goes with the old adage that if everybody’s going to jump off a bridge, you know, would you do it? You probably heard that as a kid, right?

Tim Baker: Yeah, exactly. Yeah, well, it’s like everyone else is doing it. And that’s the question you get back. Yeah, yeah. I don’t want to hear that, though. Yeah, really, what we’re talking about here Tim is again, for the individual to kind of conform to the behavior of a larger group. And it’s typically based on emotional — it’s largely emotional rather than on a rational basis. So this could be where you hear — and I always bring it up — you hear people always talking about, bitcoin or cannabis or whatever it is. And you do that because that’s what the greater, that’s what your friends are doing, that’s what your colleagues are doing it. And as an individual, you probably would not make that same choice. But it’s a little bit of the FOMO, Fear of Missing Out, that sometimes drives this. So we saw this in the subprime mortgage crisis where people were just buying real estate, they were mortgaging their house, putting second mortgages on their house, they were putting as much into the mortgage because their neighbor did this. Or same thing with the .com crisis where everyone, if it had a .com after it, people were following each other and saying, we’ll put $100,000 into cats.com or whatever it was. So actually people taking money out of their retirement to buy stocks in this. So typically, this is where you kind of want to hit the pause button and say, does this really make sense? Am I conforming to the social pressures? Is this where it’s strength in numbers? And sometimes the contrarian view, in a lot of ways, is a better view. And this often happens with inside mutual funds. So like when you have a mutual fund manager that is managing billions of dollars of stocks and bonds inside that mutual fund, sometimes he or she is subject to that herd mentality, not because of him or her, like of their behavioral bias, but because of the herd mentality of the shareowners that he’s basically trying to manage their money for. So if people are exiting from that mutual fund and they’re basically redeeming their shares, he has to essentially cash out of his investments or her investments to make sure he gets the cash for that mutual fund person that’s exiting. So the herd mentality can be rampant up and down the investment world. And it’s just important to know if you’re caught up in that. And then again, it’s kind of why we believe that index funds that basically diversify the market where you have exposure across the market is the best way to go because you get less caught up in this herd mentality.

Tim Church: Right. And if you’re going for that buy-and-hold strategy for the most part, then you’re just basically going to ignore a lot of this news when people, masses, are changing their positions or holdings on something like that.

Tim Baker: Right, exactly right. And again, sometimes with — oftentimes with investing, less is more. So a lot of times, inaction is much better than overaction and constantly — and this is something that Ulbrich and I talk about is sometimes he talks about he just wants to meddle more, meddle in the investments. And typically, that’s not the best way. And often, that’s because you’re reacting to some of what other people are doing or the news or something like that.

Tim Church: So one of the things that always comes up in personal finance, and really, you coudl sum a lot of this up, is how you determine how much you spend today versus how much you spend tomorrow for savings, for retirement, and in your investment. And when we talk about this bias of hyperbolic discounting, also referred to sometimes as present bias, that you have this tendency to prefer rewards today that may be smaller or similar and giving up something that could be much greater down the road. And really, this is sort of the main reason why people don’t contribute enough to their retirement or possibly even anything because they want to spend and get that pleasure today because the perception is that the pleasure and emotional satisfaction of that today is going to be greater than what they could have later on. So how do you see sort of this play out, Tim, with some of your clients but just in general with investing?

Tim Baker: Yeah. I think hyperbolic discounting is typically, when I say, hey, Tim, if you’re my client, we have to make sure that we’re taking care of the Tim Church today but also the Tim Church of 30-40 years in the future. So and I feel like if you’re not feeling that push and pull between those two ideas, then you’re probably doing it wrong. So typically, with hyperbolic discount is given two similar rewards, people prefer the one that comes sooner rather than later, right? It makes sense. Time value of money teaches us that as well. And we typically discount that future reward by factoring in the delay in getting it. So it would be that, hey, Tim, if I offered you $100 today versus $300 next year or $600 in four years, those are all things your mind automatically calculates that and says, well, I really could use the $100 today and I don’t really want to wait for that $300. So that’s kind of what’s going on. I see often that when we combine this with loss aversion that we talked about previously, this can easily lead to that 401k inertia that we talked about. So there was a study that employers who were automatically enrolled in a default retirement contribution at 3%, after two years, 61% of those employees didn’t change from that 3% contribution, despite the fact that their employer matched those contributions up to 6%. And a little of this probably plays into the status quo bias as well that we talked about. So I think that it’s hard for us to — I often talk about this with prospective clients and even clients. It’s like, I hear you, Tim. I know I have to save for my retirement. I know I have to do these things, but I’m really under the gun with this credit card debt or with this student loan debt. And these are the pains — that’s a future Tim problem. Like I’m really trying to focus on what’s in my face. So the hyperbolic discounting, this bias is really what is in play when we’re having that struggle against, OK, how do I make sure what I need to do today and really for the future?

Tim Church: Yeah. I think you just have to figure out what that percentage to what you’re going to spend today, but also make sure you’re on track. And so I think having goals and milestones that you’re trying to hit, especially for investing, your net worth, those are really good to have so you can always keep that at the forefront of your mind. But also being able to enjoy some of the money that you can spend today and have available.

Tim Baker: Yeah, and I will say, like, if we’re doing that more consistently — and I think some of this, we saw this with Tim Ulbrich and Jess Ulbrich where TIm is definitely looking into the future, and Jess is really more like, well, let’s enjoy our family, enjoy our life. I think there’s a good push and pull between that because I think if you’re always looking into the future and you don’t do the things that you want to do, then that’s not a wealthy life either. So I think those are important things to keep in mind.

Tim Church: So what else do we have, Tim? What’s next on the behavioral bias?

Tim Baker: Tim, I think the big one that I’d like to kind of go through is the overreaction and availability bias. I think these are fascinating. And with the overreaction, in particular, because I think this will be eye-opening to some people when they’re looking at picking investments. So the overreaction bias basically means that new information is typically reflected instantly in the price of the return. But what typically happens, investors overreact, creating a larger than appropriate effect on the stock price. So as an example here Tim, would be Walgreens or Amazon or whoever releases their earnings for the quarter, and people automatically overreact, like this is either the apocalypse or we should buy. And the stock market will change accordingly. And sometimes it’s too much, and the market can be very fickle. One of the studies I thought was really interesting, it’s called the winners and losers study that was basically released in 1985 by Debaunt and Richard Thaler, who’s a well known behavioral finance guy. He’s really interesting. The study was published in the Journal of Finance, called, “Does the market overreact?” What they essentially did is they looked at the New York Stock Exchange over a three-year period, and they separate the 35 top performing stocks into a winners portfolio and the 35 lowest performing stocks into a losers portfolio, essentially tracking each portfolios of performance as compared with the appropriate index. And as it turns out, over the three-year period, the losers performed actually better. They actually beat the market index consistently. And then secondarily, the winner portfolio consistently underperformed the market. So the cumulative difference over that three years between the two portfolios was actually 25%. So what essentially happened is that the original winners portfolio became the losers, and the losers portfolio became the winners. And this typically happens because investors tend to overreact. So for the losing stocks, investors overreacted to the negative news, driving the price of the shares down. And over time, we saw that the pessimism was outsized. And then the losing stocks actually began to rebound. And the same is true in reverse with the winners and that the enthusiasm over the winners was overblown. And you kind of see this as a reversion to the mean and oftentimes, so when we talk about using things like MorningStar ratings. You’re typically, if you’re a four or five MorningStar rating, you’re more likely to be a one or two MorningStar rating. So these are just how MorningStar funds — they basically look at mutual funds and ETFs to see if they’re good or not. You’re generally looking at past performance, which is not a good indication of future performance. So that’s really what the overreaction bias. And then quickly with the availability bias is we’re really looking at where individuals tend to heavily weight decisions that are most recent. So in the real world, if I’m driving, and I get a speeding ticket, I’m more likely to drive the speed limit soon after that ticket because I’m still feeling the burns of that. And this is not necessarily rational because I’m still just as likely to get another speeding ticket or not. So that would be really availability. And we can apply this to the way that the stock goes up and down in more recent times. So those are two biases I think that are really interesting to kind of take a look at and see how they play into our own investor profile and how we look at our portfolios and that part of our financial plan.

Tim Church: So Tim, I think we talked about a lot of the core biases around investments and personal finance in general. And I think that they’re something that is so important to be aware of just because of the irrational behavior that we have. So I guess, what practical advice would you give people just to kind of sum up everything that we talked about in terms of, you know, why should you care about these? And how can it help you be better with your finances and make better decisions kind of ongoing?

Tim Baker: Yeah, I think practically speaking, I think a lot of these things can be solved with having a portfolio that is well diversified and low cost and where you don’t have to do a whole lot of meddling outside of the rebalancing of basically locking your percentages back into focus. I think practically speaking, that is typically the best way to go. I think also, if you do feel overconfident, I think that will naturally happen where you’ll probably be humbled. I think it’s happened to all of us that have dabbled in kind of individual stocks and thinking that I’m really the smartest guy here and I can be the next Warren Buffett. I think also, being aware of if you do have confirmation or hindsight bias and to be more open to outside opinion and see if it’s actually based in fact and things like that. From a loss aversion, understanding that I think in the investment world, you have to take intelligent risk to get in front of the things like tax and inflation and that the probability or our thoughts that losses feel more painful is really an irrational — it’s just how we’re built. So I think it all points back to having a passive portfolio that you don’t have to do a lot of work with. And I think also — we’re talking about investment a lot in this month — is have a second opinion. Whether that is a friend, a partner, a parent, a financial advisor that’s going to look at your particular case or your particular investments and give you objective advice. And I think that, obviously, I think that is something that I think is very valuable because sometimes, we can get in our own heads, and we don’t really see the benefit of an outside opinion. But I think that’s often the best way to make sure that you’re sound as part of your financial plan.

Tim Church: Yeah, absolutely. I think you’ve got to take the blinders off. And especially when you’re going to make some really important or key decisions is get someone else’s opinion. You know, that could be a financial planner, it could be a spouse, significant other, or friend that you trust in. But just to get away from that. And I think just to highlight what you had mentioned about your strategy around your investing. If you’re somebody that’s buying and holding, and you’re really trading or changing your funds, you’re just either increasing your contributions or trying to do some rebalancing, is that if you’re somebody that is very emotionally responsive to the news or changes in the market or things that you hear, I mean, one of the best strategies, maybe don’t put your account balance readily available. As it can ebb and flow day to day, I think sometimes, like it’s so accessible with technology, with Mint apps, that you can see what happened to my account and what happened tomorrow? And if you’re somebody that’s really, that can’t take that emotional roller coaster, that maybe you make it very difficult to even get access to that.

Tim Baker: Yeah, so much with investment is less is more. And you can apply that to a lot of different parts of your investment strategy, but just like looking at it and messing with it is probably better. The inaction is probably better than overly concentrating on that. And like I said, when there are downturns in the market, although I preach to clients that the market will take care of you over long periods of time, it’s very predictable over long periods of time, it’s not fun to be in that down market because although the losses aren’t realized, meaning that we’re not cashing out in that moment because a lot of us have many years left until retirement, you still feel that loss. You still feel that loss, and it still can be a cloud that hovers over you. So even though I preach that, I feel that. I still feel the weight of the client assets that I’m managing. But I have to just remind myself that over time, the market will take care of us. And a lot of it is less is more when it comes to your investment strategy.
Tim Church: Definitely, totally agree, Tim. And I think it was a great topic to get out there are really is a great way to kick off this series we’re doing for the whole month on investing. So please check out the future episodes we’re going to do this month. We’re going to talk about how to get your 401k on track and how to analyze that, and then also some of the priority around investing, and then also some of the ways that you can do the investing either yourself or through some of the roboadvisors or hiring a financial planner. So be sure to check those out.

Sponsor: As we wrap up another episode of the podcast, I want to again take a moment to thank our sponsor of today’s show, CommonBond. CommonBond is a on a mission to provide a more transparent simple and affordable way to manage higher education expenses. There approach is no big secret…lower rates, simpler options and a world class experience…all built to support you throughout your student loan journey. Since its founding, CommonBond has funded over $2 billion in student loans and is the only student loan company to offer a true one-for-one social promise. So for every loan CommonBond funds, they also fund the education of a child in the developing world through its partnership with Pencils of Promise.Right now, as a member of the YFP community you can get $500 cash when you refinance through the link YourFinancialPharmacist.com/commonbond. Again, that’s YourFinancialPharmacist.com/commonbond. And one last thing if you could do us a favor, if you like what you heard on this week’s episode, please make sure to subscribe in iTunes or wherever you listen to your podcasts. Also, make sure to head on over to YourFinancialPharmacist.com, where you will find a wide array of resources designed specifically for you, the pharmacy professional, to help you on the path towards achieving financial freedom. Have a great rest of your week!

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