The boom is back. Unemployment hasn’t been lower in a very long time. There’s some evidence that wages are starting to tick up as well. Employee’s are having confidence to leave their jobs. All of this is good news. The bad new is that a recession is coming. I don’t mean this year, I don’t mean next year, but sooner or later its going to be mass layoffs and a stock market crash. (And I mean like a real crash, not the baby pullback we’ve experienced during the last few months). What should you do?
Don’t sell your stocks
There could be a lot more economic boom between now and the next recession. The stock market could do any number of crazy things. It could double before the next recession hits. This might be the lowest the stock market gets for the rest of your lifetime, it’s probably not the highest it will ever be during the rest of your lifetime. Our goal is to accumulate assets. These assets will in turn provide us with more cash. Don’t sell the assets!
Do diversify your income
If you only have one income stream now is the time to start making new ones. It’s not as much fun to have to come up with a new way of making money if you just lost your job and you have six weeks to sort it out before you start missing house payments. The goal, especially for folks in debt, is to be able to make your rent/house payment without racking up more debt or dip into savings. We’ve talked about some potential ways to make money before. If you haven’t already started working on something, now is the time. Whatever you do make sure that you don’t rely to heavily on one client. Contractors are generally the first to go when the economy hits the fan. Even if the economy doesn’t dip into recession this process works. If you were an oil worker you probably would have felt more secure over the last year if money was coming in from other sources.
Keep fixed expenses small
Your fixed expenses can make life painful even if you’re able to pull in a small amount of money from side gigs. Your income is more diversified as your fixed expenses decrease. If your rent is $500 per month and you pull in $1000 from a couple side jobs, contract work, and dividends then you’re probably adequately diversified against job loss. If you have the same side income but have a $3,000 house payment then you don’t have any significant diversification. Add up your fixed expenses like house payments, taxes, health insurance premiums (keep in mind these will be higher if you lose your job), car payments (bad), credit card payments (very bad!). Then try to make sure that you can earn about twice as much as this from work unrelated to your main source of employment. I’ve heard the argument from high-earning engineers, that the hourly rate they can get for side work is simply dwarfed by their current job.
What about emergency savings?
You need to have some emergency savings. You should make sure that you’re in a situation where you can get your hands on several thousand dollars in case of an emergency. That being said, if you’re properly diversified fewer things will register as an emergency for you. According to the Holmes and Rahe stress scale “dismissal from a job” ranks above “death of a close friend”. Losing your job is going to be stressful, it’ll be a little less stressful if you have enough emergency savings to see you through to your next job. The trouble is that you don’t, in advance, know the amount of time until your next job. Instead you get to watch your pile of cash dwindle while you try to replace the job you had. It’s stressful to try to set up a whole new income stream during this time when you’re trying to replace your career. If you have separate income coming in the situation is substantially more comfortable as it could continue nearly indefinitely. No melting through your hard earned savings while you try to take any job that sails by.
There is certainly a student debt problem in the US. Since bankruptcy laws were changed so that students could no longer discharge their debt through ordinary means, borrowing standards have slackened, interest rates have gone down, and tuition has gone up. Consequently, every couple of months someone publishes an article about how crazy their personal student debt situation is and how reasonable they were in acquiring the student debt. Here is the recent example: Betrayed by the Dream Factory. The answer they naturally propose is more regulation on schools, but also simply having someone else pay it. Doesn’t matter who, either make the bank write it off, have the federal government come in and clean it up. Part of the problem is that the amount of outstanding student loan debt is about $1.4 trillion. If the federal government forgave that much debt it would be more than all of the federal discretionary spending, including the all of the military spending, in a year. You could shut down the government entirely, only keep doing the mandatory spending like social security. Doing that still wouldn’t save enough money to pay for full student loan forgiveness. In order to pay for total student loan forgiveness you’d have to take in about twice as much personal income tax as we currently do. To say the least, the situation has gotten out of hand.
You might instead argue that the banks should have to pony up and just write off the student loans. Unfortunately total equity in american banks is pretty similar to the size of the total student debt. Something like this would wipe out the banking system entirely. That would probably not happen in an orderly fashion and bank runs would ultimately result in a much larger federal obligation than the original 1.4 trillion. It therefore seems unlikely that we’re going to have total student loan forgiveness anytime soon. So what’s someone with a completely unreasonable amount of student loan debt to do?
For those of you who haven’t read the article, let’s break this down. Samual is a Bioethicist that makes $70,000 per year and has $190,000 in student debt. That’s a lot of money. It seems unlikely that someone else is going to make those payments for him. The good news is that this debt can be paid off. This is Thousandaire, our whole shtick is paying off all of our debt and saving up a thousand dollars. Those of you who want to go further and become financially independent will have to save up far more than $190,000. Sam (I hope I can call him Sam) is feeling fatigued about his debt, because he started with $200,000 and has hardly made any progress at all. Sam doesn’t provide a detailed breakdown of his student debt but we’re going to go ahead and try to make a worse case scenario guess:
- $100,000 private student loans: Interest Rate 8.5%
- $90,000 federal student loans: Interest Rate 5%
Total interest payments on these loans is $13,000. Now the rule of thumb I like to claim is that if you live like a student for every year you were a student, you’ll pay off your debt. This is damned inconvenient to be sure, but better to do it sooner rather than later and end up paying even more. Basically the argument goes thus, society supported him and his education for 5 years. To pay us back he’s going to have to live like an ascetic for five years. Fortunately he has some education in philosophy which should equip him to handle this. Unfortunately, it looks like he’s got a case of the not-my-faults. This is bad because, its one thing to live a hard life if you feel like you chose it, it’s another entirely if you feel that it was forced on you. When the going gets hard it’s much easier to give up if you feel out of control and a victim. Agency is largely the key to happiness, and by giving that up things will be much harder.
Pay off $190,000 in five years
Our first test is, is this even theoretically possible. He makes $70,000, in five years that’s $350,000. This is more than the under $250,000 he’s going to have to pay back including interest over the next five years. The remainder is about $20,000. Fortunately he’s come to the expert of living on less than $20,000 in a high cost of living area. The plan (obviously) is to pay off the highest interest debt first, hopefully this’ll make things easier.
Our hardest cost to control is simply going to be taxes. The IRS is kind of a pain in the neck about getting what they think they deserve. First off you’re going to get hit to the tune of 7.65% for payroll taxes (you know, social security and medicare). This is going to cost $5,355 right off the top. Yikes. Then we need to calculate income tax. You get a very small deduction for your student debt, $2,500 last I checked. This means that your modified adjusted gross income is $67,500. Unfortunately we’re not going to be able to use any fancy tricks to reduce this, because you need all of it right away to reduce your debt. We’ll then go ahead and take the personal exemption and standard deduction of $10,350 for 2016. This brings our taxable income to $57150. My estimate for the income tax bill is therefore $10,060, combine that with the payroll taxes and that gets us: $15,415. That’s deeply depressing, but what are you going to do, right? This leaves us with $54,585 left. This leaves us with $4,550 per month to play with.
Now this is going to require some guesswork, but based on the employer survey of health care benefits the cost should be less than $100 per month. This leaves us with $4,450 per month remaining.
Alright, Sam. First things first, you’re living with a roommate for the next five years. Maybe two roommates. Why? That’s how college works, and until you’re out of student debt, you’re living like a student. Washington is expensive, and I’ll assume that this fancy bioethics job is in an expensive area in Washington. According to expatistan that means that a pretty small apartment is $2,300. You’re splitting that small apartment until further notice. The total monthly cost should therefore be $1,150. This means we have $3,400 per month remaining in our budget.
Maybe you go out for dinner, or eat fast food occasionally. Not for the next five years. Living like a student means its back to rice, beans, lentils, fish, and the occasional bit of chicken. Anything that comes in an individually wrapped container is out. The goal here is to maximize nutrition and calories per dollar spent. Meats are out beans are in. Ice cream is out bananas are in. If you’re willing to cook for yourself you can manage healthy meals on $200 per month. This leaves us with $3,200.
Living like a student definitely means no cable. You can have internet and a cell phone. It can’t cost you more than $60 combined per month (at least you get to split it with the roommate). Figure it out. Gas, electric, water and trash should come in at less than $120 per month. I’m going to assume you’re roommate is a pain about this though and it does cost you $120. After you split it with your roommate that should cost you $60. This leaves you with $3,080.
If you have a car strongly consider selling it. You’ll be better off with a bike. If you need a car try to do the bike anyway. I assume that you don’t have kids. You can live for five years without a car, unless you’d prefer to live the rest of your life in debt.
If you’re fairly certain that there is no other conceivable solution. (Or if you’re too lazy to bother trying anything else), you can go ahead and keep whatever car you have. Unless of course you’re making payments on the thing. Then it gets sold and you buy a $1,000 beater. Students don’t drive nice cars. They drive beaters. That’s how it works. Gas shouldn’t cost you more than $50 per month and your (liability only) insurance shouldn’t cost you more than $80 per month. This adds up to $130. This takes us down to $2,950.
Your new hobbies are at the library and public park. Hope you like reading and hiking.
Nope. You’re a starving student, and it’s more important to prevent the starving part than to make sure you’ve got netflix. Plus you’re new work is going to take up a pile of your free time.
I remember fondly being in school while working 10 hours a week. Fortunately you’ve already worked while getting a master’s degree (no easy feat) so this should be quite simple for you. You’ll need to work 10 hours a week at an hourly rate of at least $20 after tax (so charge $30/hr before tax). It could be writing, it could be advocacy or it could be tutoring. All told this should make you an extra $800 per month.
This leaves us with $3,750, paying off your student debt over the next five years (the math assumes we pay the minimum on the low interest debt and focus on the private debt first). About $100 per month is available for incidentals. Your private student loan debt dies right near the end of year three and you wipe out the federal debt at the end of year five. You then can face the rest of your life not with:
My situation has finally stabilized, and I should be able to avoid default, though things haven’t improved otherwise. My payments are still crushing, they will be around for decades, and they severely limit my life choices.
But instead with:
I finally feel free, I don’t have to worry about default. My payments are gone, and my life choices no longer feel limited. All I had to do was something really hard, one time, for five years.
Yes, I do realize I’m asking something very hard of him, and it’s a lot easier just to ask other people to pay off his debt. I think it’s most likely that he’ll not do these things, but I figure if he can fantasize about a world where other people finance his dream jobs, I can fantasize about one where people take responsibility for their choices.
Rebalancing your portfolio is a time honored tradition, that seems to happen at the beginning of the year. Often you’ve assigned that maybe 20% of your portfolio will be in bonds, 60% in United States stocks and 20% in foreign stock markets. The percentages aren’t really the point here, but let’s just suppose that, for your portfolio, those were the weights you chose. Over the course of the year some parts of your portfolio go up, and some parts of your portfolio go down. This leaves you with a weighting that you may not have originally intended. For example, if the US stock market crashed but foreign markets did well you might end the year with a weighting that looks more like 25% in bonds, 40% in US stocks and 35% in foreign stocks. The standard prescription for this situation is to sell a bit of your bonds, and a bunch of your foreign stocks in order to buy more US stocks, so that you return to your original portfolio weighting.
Clearly the goal here is both to return yourself to a weighting you originally thought was wise, (this should dovetail with your investment policy statement) and to force yourself to sell high (the foreign stocks in our previous example) and buy low (the US stocks). The idea is that, over time, you’ll do better in the market as a whole because you were able to take advantage of times when the various markets were relatively cheap, and were able to maintain some gains in markets that had run up over the last year. This additionally keeps you from taking more risk than you’d intended. For example, if you were near retirement and the year was 1997. In that year the S&P 500 went up 33%! That could mean that your portfolio was suddenly more like 35% bonds and 65% stocks. This would mean that, going into your retirement, you have a much riskier portfolio than you had intended. You solve this by simply selling your excess stocks, and buying bonds. Suddenly your expected risk is back roughly where you left it.
As you might be aware by this point, in my ideal portfolio you never do anything except buy more assets. Whenever you sell an asset, even an index fund, you trigger capital gains taxes. Triggering capital gains taxes will create a drag on your returns. A good example comes from Charlie Munger from the Berkshire Hathaway Annual Meeting 2008:
Another very simple effect I seldom see discussed by either investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15 percent per annum and you pay one 35 percent tax at the very end, the way that works out is that after taxes, you keep 13.3 percent per annum. In contrast, if you bought the same investment but had to pay taxes every year of 35 percent out of the 15 percent that you earned then your return would be 15 percent minus 35 percent of 15 percent or only 9.75 percent per year compounded. So the difference there is over 3.5 percent. And what 3.5 percent does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
For reference 3.5% is roughly a doubling every 20 years. So if we never want to sell because we’ll lose out on a few percent, how can we keep our portfolio balanced?
Fortunately, as long as we’re young and have a relatively low net worth. As long as your income is larger than your portfolio you can pretty well rebalance without selling. If your portfolio is out of your desired balance you can simply tilt your new contributions to try to catch the balance up to what you originally intended. For example, if after the pullback in the market we’ve had, you’ve found that the percentage of your portfolio invested in stocks has fallen maybe 10% lower than your target. To make up for this you could simply throw your entire contribution at stocks until the gap was righted, or even better you could continue making your regular contribution and split it up as usual, but also make extra contributions to catch your stocks back up to where they ought to be. These plans are feasible if you’ve got a $60,000 portfolio, and now your target is off by $6,000. If you have a $600,000 portfolio this all requires some more thought. You’ll have to try to determine if losing out on some of your return over the long haul is worth reducing your risk by keeping your portfolio on target. My suspicion is that you’ll find it worthwhile.
So in December the Fed hiked rates 0.25%. Now you want to know how this should effect your investing strategy. The short answer is that it shouldn’t. If you do anything differently because of the rate hike, you are over-reacting. The Fed rate hike, however, might have some impact on you. Let’s really quickly go over what a rate hike is and what it does and doesn’t impact.
What is the Fed “hiking”
When the media reports that the Fed is hiking rates, they generally mean the Fed Funds Rate. This is the interest rate that banks charge each other to loan money overnight. In turn the overnight rate directly impacts the prime rate, which is the lowest rate at which money can be borrowed commercially. After all, why lend commercially if you could instead simply lend at the overnight rate. This has gone from 0% to 0.25%. In other words you get a quarter annually by lending $100 at the overnight rate, go nuts.
What this directly impacts
Since the prime rate is effected anything set based on the prime rate gets boosted by a tiny bit. This includes credit card interest rates and auto loan interest rate. Now, our goal as Thousandaire’s is to not pay credit card interest and auto loan interest. If you are paying these interest costs this hike is tiny anyway, costing about an extra $2.50 per thousand dollars of debt per year. In principle, this will probably also impact rates offered by short term CD’s and savings accounts. Again this isn’t much, and its starting to look like the Fed might not continue to raise rates [link article on fed rate raising slowdown]. If the rate raise makes you feel that you really need to pay off that credit card or that car, I think that’s great. If it stokes you to buy a three month CD, fantastic. You probably don’t need to worry about it though.
What this does not directly impact
Every day I drive to work I hear some radio commercial about how you need to refinance because the fed is raising rates. This is a load being shoveled by guys who sell mortgages. Mortgages are long term rates, the fed has a very difficult time controlling long term rates. There is some evidence that they were able to push down mortgage rates during QE and “operation twist”. The fed might be able to push up long term rates by selling mortgages and other long term instruments. If inflation expectations stay low and GDP growth stays low long term rates will probably stay low despite a couple small increases in short term rates. Additionally, given negative interest rates abroad, there is a lot of capital in Europe and Japan looking for somewhere safe to invest money. If rates stay negative internationally, I’d bet that mortgage interest rates will stay low. You’ll notice that rates have even dropped over the last month or so. Current 30 year mortgage rate is 3.88% as of February 3rd.
What not to do
In principle increases in the federal funds rate should reduce the value of stocks. The value of a particular stock is the value of all of the future cash flows of the companies discounted to the present at an appropriate interest rate. This means that increases in interest rates reduce the value of stocks in principle. Unfortunately, this is well known, and as soon as rates seem likely to go up the stock market accounts for that information. Even though “rising rates are bad for stocks” you do not sell your stock holdings. You can’t control interest rates. You can’t predict their behavior better than the market (even federal reserve economists have substantial trouble doing this). You can control transaction fees and taxes. Selling generates both. The goal of stock ownership is to treat your ownership interest as an interest in a business and simply sit on it for as long as possible.
I ran across a really common objection to fully funding your 401(k): Disregard a terribly common bit of advice about your 401(k). This is certainly one of the more well written version of this objection, but it’s not new. Boil the article down though and really it’s the common whine that if you put money into a 401(k) you won’t be able to get it back out (frankly, given the way most people manage their finances, that’s a big advantage). It straw-mans a bunch of personal finance theory, then assumes that consumption smoothness (spending the same amount of money every year) is necessarily more important than other goals, like control over your time.
The straw man
Schrager makes a key assumption at the beginning of the article. She claims that personal finance folk are prioritizing fully funding your 401(k) before any other personal finance goal, like saving up an emergency fund. She doesn’t link where she found this, and the links she does provide don’t seem to over-prioritize the 401(k) at all. This is all too common among critics of fully funding your 401(k), it’s important to make funding your 401(k) sound as scary as possible, what could be worse than going without an emergency fund to keep your 401(k) funded? I believe she saw someone with a list personal to them, somewhere that prioritized their 401(k), but writing a whole article about something that essentially no one thinks is a good idea sounds terrible.
Schrager argues that people with volatile incomes shouldn’t necessarily fully fund their 401(k), and she doesn’t fund her 401(k) beyond an employer provided match. I’m glad that we agree that a bunch of free money is still worth it. She further claims that you can go ahead and invest in stocks outside of a 401(k). She further goes on to throw the IRA into the mix as well. This is perplexing to me, simply because the Roth IRA makes a great emergency fund if you’re like Schrager and aren’t planning on investing in it anyway. (I should clarify, the Roth IRA makes a great emergency fund, but it’s an even better retirement fund. Since your tax sheltered space is limited, I’d strongly suggest contributing to a Roth and an emergency fund, but if you’re gonna be all I’m too good for retirement accounts about it please fund the Roth.) Basically her argument boils down to being scared of the penalty and trying to engage in consumption smoothing.
Basically the whole argument reads like someone who doesn’t really understand how 401(k)’s work or what the most common personal finance goal actually is. This is really strange for someone who specializes in pension economics. Honestly I wouldn’t bring it up if I wasn’t so sure she was misunderstanding key points about 401(k)’s and personal finance in general. Schrager, you really can have your cake and eat it too. If your goal is “consumption smoothing” you should note that investing in stocks is probably a bad idea. Stock returns are anything but smooth and it’s entirely possible that your income could be correlated with investment returns. Any money going into stocks might as well go into a 401(k), because you can take money out of a 401(k) if you lose your job (the cause, I assume, of the income volatility). Yes you do take a penalty, but you also have a substantially lower tax bill in years when your income is substantially lower. The other important use of the 401(k) is that it allows your total tax bill to hit important breakpoints in the tax code. If you have a pile of stocks (which you apparently do) you should note that you pay no taxes on dividends and capital gains if your after 401k contribution income is below ~$75,000 for those that are married filing jointly. This savings could easily be enough to justify paying the 10% penalty later. Furthermore, money in a 401(k) compounds without taxes. This is often overlooked, but can pay the penalty by itself. For the same tax bracket, you should keep in mind that the total effect of a 401(k) is mathematically equivalent to not taxing earnings on contributions. If you pay an additional 15% in taxes on earnings in stocks outside of your 401(k), then as soon as earnings are about as large as the initial investment you’re doing worse than paying the 10% penalty. This, based on historical stock data, would probably happen in as little as 10 years, so it’s not really fair to use the 59.5 number.
Lastly, most of the people I talk to in the personal finance community rate control over their time far ahead of spending the same amount every year. Any retirement contribution you make today is two similarly sized contributions you don’t have to make next decade. If you overshoot, then you just retire early. Alternatively, when the next job loss comes around you don’t have to panic that you aren’t going to be able to fund your retirement.
It’s that time of year again. Tax season! (I’m not sure why I find it so exciting, but it evidently has something to do with being the sort of person that would rather sit writing for a personal finance blog rather than watching TV, playing video games, or participating in underground Lucha Libre matches.) It seems like a good time to touch on the things that are a little different for our little community. If you’ve been following carefully you probably don’t just plug your W-2 into Turbo-Block and forget about it.
Sometimes this can be a little difficult. If you do contract work for a big organization they’ll generally send you a 1099 if you make over $600. If you make a really small amount of money say less than $100, some folks tell you not to worry about it. Those are terrible people. You owe the IRS that money. Some laws I don’t take seriously, I jaywalk from time to time. Some laws many people don’t take seriously, I don’t think I know anyone that had their first drink after 21. Don’t screw around with the IRS. I always pay every penny I owe on my taxes. When I order something on amazon I mail State of Colorado a check for 2.9% of the sale value.
Make Use Of The Saver’s Tax Credit
This is the dumbest tax credit I’m aware of. I mean you get a discount on your taxes if you’re rich enough to not be living paycheck to paycheck. Basically, it seems to be a bonus you get for using other tax shelters really well. I couldn’t be happier to take advantage of it. By my math you can use it to pay $0 in federal tax even if you already make $44,750 as an individual. It is completely and utterly ridiculous, you can basically double that figure if you’re married and filing jointly. Sure, you need to throw most everything into 401k’s, IRA’s and HSA’s, but it’s not like maxing those is a terrible idea on its own. See our article here.
Most Investment Expenses Can Be Deducted
One bit that new amateur investors often miss is that all investment expenses can be deducted against investment profits. Let me repeat that, all investment expenses can be deducted against investment profits. Your brokerage will handle the easy part. Your cost basis is an expense, your brokerage fee’s are an expense. Any decent brokerage will calculate these costs and report the difference (hopefully profit) to you. You need to add in any other costs you might have had. For example, a subscription to the Wall Street Journal, any investment books that you purchased, if you subscribe to an investment newsletter. All of these are deductions.
Can You Deduct Travel To An Annual Meeting of Stock You Own?
The only major expense associated with investing that you can’t deduct is cost of travelling to an annual meeting of a stock you own. This is unfortunate, but ultimately sensible on the part of the IRS. There are enough companies in the United States that it was pretty easy to simply find a place to go, find a company with an annual meeting close enough, and deduct your plane flight. Everything else related is fair game. Depreciation on your laptop can even be deducted as a 2% item if you use it for investment purposes. If you’re looking at any non-standard or large deductions in this area it’s a really good idea to ask a tax professional. I’m a scientist. That isn’t a defense when you get audited.