One of my role models in the world of personal finance blogging is Frugal Professor. He is an actual professor, with five children, and is well known for his ability to optimize taxes. He regularly posts complete financial updates on his road to financial independence, as well as some other real personal finance gems. My favorite is his Hierarchy of Savings post, which may be the best guide on the internet for which types of accounts to prioritize for your savings. I routinely recommend his list to my family and friends. So, you can imagine how excited I was when Frugal Professor himself agreed to do a Q&A with us! Thanks, FP, for the great responses! I hope you all will enjoy reading them as much as I did.
Joey: One of the things that really attracts me to personal finance is how successful you can be by following a very basic approach, like the 3 steps on your website. But underneath the simplicity are layers of complexity. What depth of personal finance knowledge would you recommend the average non-financial-nerd Joe know? Is it essential for everyone to understand IRA conversions, be able to calculate their effective marginal tax rate, and find the perfect optimization of retirement account contributions for their situation? Or should they just hire a “professional” to make sure they don’t miss anything as suggested in your disclaimers? 😉
FP: This is a good question. My three broad steps: live below your means, reduce your tax burden, and invest the savings wisely encompass the entirety of personal finance. It’s not rocket science. The real complexity arises when thinking about how to really optimize, such as optimally deciding between Roth and Traditional 401k/IRA contributions. In order to really understand these topics well, I (unfortunately) think you need to get into the nitty gritty of the US tax code. Doing so will empower the individual to understand the pros and cons of choosing a Roth over Traditional (or vice versa).
It was only through the writing of my draft “book” that I realized that the appropriate tradeoff to make between a Roth and a Traditional 401k/IRA is the marginal tax rate today vs the average rate in retirement. I’m a huge fan of people investing the hour or two to read through my draft “book” to understand the tax code and empower themselves to make informed financial decisions for the rest of their lives. If people don’t want to invest the hour or two to read my draft “book”, then you can take my word for it and adhere to my proposed Hierarchy of Savings post.
I’m never a fan of hiring a “professional” financial planner. The great irony of financial planning is summarized by this brilliant comic strip:
If you want a good chuckle, check out this post: 10 investing lessons from Dilbert creator Scott Adams and Vanguard Founder John Bogle. Scott Adams was well ahead of his time when it came to index funds. His comics about the wisdom of index funds began in the 90s as far as I can tell. He loathes financial advisors.
Joey: Let’s talk about Roth vs Traditional retirement accounts. Go Curry Cracker, you, and I (just casually putting myself in the company of celebrities) seem to favor Traditional. One of the main push-backs I get is that we don’t know what taxes will be in the future, so we might as well pay an OK tax right now if we’re in the 12% or even 22% bracket for the guarantee of no taxes in retirement. I loved this quote from your book:
The ultimate hedge against tax rate increases is a frugal lifestyle.
Can you comment briefly for our readers on why you’re not worried about changes in tax rates in retirement?
FP: Thanks for the hat tip to the “book.” I think it’s a really profound point I make in the book. There is power in thinking about taxes strategically. During your working years, to lower your tax burden you can: 1.) work less, or 2.) jack up traditional 401k/IRA or HSA contributions. Given the relatively low contribution limit for tax advantaged accounts and a general unwillingness to work less than full time (for those that are not at FI), our tax burden is somewhat fixed while we are working. This isn’t to diminish the importance of maxing out tax-advantaged accounts, but rather an acknowledgement that these accounts are only so big (and represent a small percent of a high earner’s income).
So with a relatively fixed tax burden during your working years, you have to think about how you might optimize on the withdrawal end of things. This is where the power of understanding the tax code really shines. If you are married in retirement and it only costs you $24k/year to live, you can do Roth conversions up to $24k/year and not pay a penny of taxes in retirement. If you need more to live (admittedly likely), you can harvest capital gains & dividends tax free up to a very high limit. This is precisely what Jeremey at GCC has done for about a decade now, and his 2013 blog post documenting this strategy remains the most powerful blog post I’ve ever read in my life. In it, he documents how he has a combined income of close to $100k and pays $0 taxes on it.
Given the wealth accumulation equation,
Future wealth = Starting wealth + sum of income from now to future – sum of taxes from now to future + sum of net interest earned from now to future – sum of living expenses from now to future
I immediately realized that achieving 0% tax burden in retirement would drastically increase my lifetime wealth. But there are actionable steps to do now to be able to enjoy a tax-free retirement, mainly: 1.) Stuff traditional accounts to the brim during working years, 2.) Stuff the rest in taxable brokerage accounts but never transact (with the exception of tax loss harvesting1You buy an investment (like VTI), the stock market crashes, you sell VTI at a “loss”, only to buy it >30 days later. You report the “loss” on your taxes, which decreases your taxable income by up to $3k/year (that’s the maximum allowed). That’s tax loss harvesting.), so as to accrue massive long-term capital gains, and 3.) Live a relatively frugal lifestyle to exploit the 0% tax region in retirement, something a person requiring $150k/year would never be able to achieve.
If you want a more detailed response to the question, see the section “A Note about Future Tax Rates” in my draft “book.”
Joey: On a somewhat related note, for people with kids who want to save for college expenses, what do you think of using children’s Roth IRAs rather than dedicated educational products2Tax advantaged accounts dedicated to paying for education expenses.?
FP: I’m a huge fan of prioritizing the funding of a child’s Roth IRA above a child’s 529 plan. For all intents and purposes, they serve the same role during college while the Roth has two distinct advantages over the 529: 1.) doesn’t count against you in the FAFSA, and 2.) If there are unused funds after school (i.e. scholarships are higher than expected), then the funds can be used for other productive purposes (tax-free first-time home purchase, tax-free retirement, or alternatively tax-free principal withdrawal for wedding, car, or whatever).
There are two downsides: 1.) Can’t contribute to child’s Roth unless they have earned income, 2.) Interest cannot be used on child’s education. My oldest is almost 12 and next year will get W2 employment by working as a laborer in the cornfields of the midwest doing a job known as “detassling.” I’m ecstatic for the opportunity for her to have W2 wages, which I will match dollar-for-dollar into a Roth IRA. Downside #2 is diminished when you realize that most people start saving for their kid’s college too late, meaning that the majority of their savings will be principal, not interest.
Joey: Follow-up question: In the case of saving for kids college, would you recommend the same thing to people who’s children don’t get paid/have a W2? i.e. use your own Roth IRA instead of your kid’s?
FP: In that case, I’d say a definitive no. If a parent isn’t in the position to pay for college out of non-retirement savings or cash flow, I think the student should 1.) go to a cheaper school, or 2.) take out loans in their own name. To be honest, I don’t really understand the mania surrounding paying hundreds of thousands of dollars for an undergraduate degree. But maybe that’s my naivety speaking since I’m not an ivy grad nor is any of my family.
Joey: In terms of investing, you talk a little bit about asset allocation3An investment strategy where different types of investments are held in fixed percentages, e.g. 75% US stocks / 25% international stocks on the blog. What do you think of the JL Collins approach of simply putting 100% of your savings in a total US stock market index funds during your working years?
FP: I think this is a reasonable enough strategy, one that both Bogle4The founder of Vanguard and the Father of Index Investing & Buffett would also recommend. I’m currently 75/25 domestic/international. Only time will tell which is more prudent. The argument against the international holdings is that most US firms are already multinational so you already have huge international exposure through the purchase of a total US fund. Another argument against international holdings is that they are more costly (in terms of foreign taxes and expense ratios). The argument for international funds is that you get added diversification. My money is on the added diversification, but again I have no qualms with the 100% domestic approach.
Note that most target date funds have a good amount of international exposure (i.e. 40% of stock holdings such as here: https://institutional.va
Joey: For a relatively lower income individual (like a graduate student) with a 0% long term capital gains rate, what do you think of selling and re-buying index funds to increase cost basis5e.g. You buy a share of VTI at age 25 for $100. Three years later, your income is relatively low and your share is now worth $150. You sell it and immediately re-buy, paying long term capital gains (0% at your income) on the $50 “profit”. Three more years later, your income is high, VTI is worth $200, and you want to sell it to help pay for a minivan. When you do, you’ll pay long term capital gains tax on a $50 ($200-150) profit instead of $100 ($200-100) had you not sold and re-bought three years prior. when the market is going up? What about harvesting losses6See footnote #1 by selling and buying a similar but not identical index fund in a major bear market (or just waiting 30 days)?
FP: Capital gains harvesting is brilliant and you should do it while you still can, so long as it does not preclude you from earning the EITC if you have kids (as I did in grad school; see https://www.frugalprofessor.co
Joey: Now let’s talk frugality. If your university is anything like Joe’s and mine, you’re likely in the minority among faculty members in terms of frugal spending habits. Do you ever find it difficult to maintain spending habits that are different from your peers, or does it ever result in awkward situations?
FP: I’m definitely an anomaly when it comes to my frugality and always have been. Many of my colleagues are in credit card debt and are doomed to a life of trivial wealth. Sure, I have less fancy lunches, cars, houses, vacations, and clothing than these peers, but these things give me no added happiness over a simple meal, craiglist bike + used Corolla, etc. For me, there is no added benefit to more consumption, so I feel that it’s the only logical path for me. In that regard, I feel zero pressure to spend like my peers because I do not strive to achieve what they have (superficially high spending at the expense of financial security). I much prefer forgoing luxuries which wouldn’t make me happier in exchange for freedom. Being stuck in a cube for 4 years at Boeing in a job I didn’t like very much taught me the benefits of clawing my way towards freedom.
Where things get awkward is when we make new friends and I know I have the knowledge to change their lives through the sharing of simple advice (i.e. tax minimization and low-cost index investing). I feel morally compelled to at least offer to chat with people, knowing very well that my intervention could easily save them hundreds of thousands of dollars in taxes and investing fees alone. I’ve shared repeatedly that I saved a colleague $20k in taxes last year by simply opening my mouth. I share the knowledge with my students even though I don’t teach personal finance. As a result, most students are a bit confused at the orthogonality of the subject matter, but it’s a risk I’m willing to bear to help push my students in the right direction.
After casually mentioning this superpower to friends/neighbors, I say something like this: “I don’t know how else to bring this up, but I have a magical talent for minimizing taxes and optimizing investments. If you cared to talk to me about your 401k stuff or anything else, I’d gladly lend a helping ear.” Most of the time, this is met with the response of “Oh, no worries. I have a financial planner who helps me out.” At this point in the conversation, my blood pressure rises but I relent and let their stupidity lead them to a life of poverty. I have yet to find a way to tactfully reframe this response: “Your financial advisor, though you perceive him/her as a friend, is a wolf in sheep’s clothing. And your ignorance will cost you hundreds of thousands of dollars over your lifetime.”
Joey: You have a pretty sweet cell phone setup with Google Voice plus Tello. Would you mind sharing what your monthly phone bill typically runs?
FP: Anywhere from $0.25/month to $2/month if I get crazy. The median is probably $1. The cost savings of doing this over the past decade+ are huge. And there is no “cost” to doing so; I’m not forgoing any meaningful cell phone functionality.
Joey: Finally, let’s get a little philosophical. If you love your job and make decent money, do you think it’s worth it to pursue financial independence before age 65+? If so, what would the benefits be?
FP: I have never in my life been upset to have options. More education has given me options. More money has given me options. At worst, if you have too high of an education, do too well in your job, and have too much money, then the status quo is to stay on the current path and get paid handsomely. What life has also taught me is that curveballs abound. Maybe your (or your spouse’s/child’s/parent’s) health fails. Maybe your industry is made obsolete (i.e. buggy whip manufacturer…..I’m not sure if Universities are about to experience a similar transition).
Education + hard work + frugality almost inevitably beget wealth. Wealth begets freedom. Freedom gives you the ability to do whatever you want, independent of financial concerns/motivations. If you aspire to do what you are currently doing until you die, then sure I can understand the argument that saving is pointless if you can guarantee perfect health and that your industry won’t collapse. Given these are strong assumptions, I think a bit of planning can go a long way building a financially secure future.
One major risk that most parents will face is the “failure to launch” of their kids. Or for that matter, the “failure to save for retirement” of aging parents. Having a strong balance sheet puts one in the position to help family members in need. We “loaned” a family member around $6k to get them through their last year of undergrad. Almost a decade later, the “loan” remains unpaid, but we knew the risks going in. Do we regret that decision? Nope. His parents were not in the position to help, so we were happy to fill that role given our financial situation. Broke parents & failure to launch are huge risks that a bit of wealth can help protect against.
Joey: If you had to give only one piece of financial advice (or you can cheat and give two7or 4, no big deal 😉) to a young adult, what would it be?
FP: 1.) Take note of how happy you were in college earning nothing and eating Ramen. Your happiness had everything to do with your human interactions with people and nothing to do with your consumerism.
2.) Upon graduating, your income is going to increase by an order of magnitude or two, facilitating the indulgence in consumerism if you follow the status quo of spending everything that enters your bank account.
3.) If you continue to live a simple life as you did in college by avoiding lifestyle creep, you will amass a large amount of wealth really quickly (particularly if you are smart with taxes & investing), enabling you to rapidly pay off any student loans and save a massive nest egg for retirement.
4.) If you save enough, you can escape the cube farm in your 30s and not die in the cube farm in your 60s like my colleague at Boeing.
Joey: What (if anything, yet) do you teach your five kids about personal finance?
FP: Our kids have “bank accounts” at the bank of dad. I pay 8% interest/year. Every bit of income goes on the sheet. Every expense goes on the sheet. My 11 year old has $500 currently and makes a few dollars/month in interest. When my kids spend money, I remind them that this has two consequences: 1.) Less money for things they want in the future, and 2.) Less interest earned in future. I also like to look at the spreadsheet with them and let them see the stupidity of their prior purchases: toys which broke too fast or candy which was promptly devoured. With the benefit of hindsight, they realize that most of their past purchases have been mistakes (I feel the same when looking at my Amazon purchase history), and try to resolve to be more prudent going forward. I’m trying to get them to break the perceived link between happiness and consumption. Only time will tell if I’m succeeding.
Joey: Thanks, Frugal Professor, for the awesome interview. It was truly a pleasure!