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How to avoid the biggest personal finance mistakes

How to avoid the biggest personal finance mistakes

For this week's blog post, we are launching a new series where I ask a financial professional five questions on important personal finance and investing topics. I'm excited to kick things off with a conversation I had recently with a friend of mine who is a financial advisor. We discussed topics such as the biggest personal finance mistakes people make in their 30's and 40's, the role of Roth IRA's for saving for college, and how to think about paying off debt or investing the difference. 


I believe it is important to share a diverse set of views on personal finance topics with my readers, especially on questions where there may be a variety of potential solutions for you. In addition to the answers from my friend I have also provided my own comments and linked to what I've written on these topics so you can compare our answers. 


1) What are the biggest personal finance mistakes you see people make in their 30’s and 40’s?

Not taking enough investment risk for long term assets
There is little-to-no use for low-risk investments (fixed income) for earning professionals in their 30s and 40s investing for goals 10+ years out. A nominal amount, like that found in long-dated target date funds, for instance, can be helpful in seeking better risk-adjusted returns or for tactical rebalancing during periods of high volatility. Otherwise the a long time horizon and current environment dictate a higher allocation to riskier assets (equities). Unfortunately, many people self-identify their investor profile (conservative, moderate, aggressive) in a vacuum – abstractly and outside the relevant considerations of the current investing outlook.

Taking on too much investment risk for short term goals
Goals like buying a home or hosting a wedding in less than three years should almost never include riskier assets. Market timing becomes more important for short-dated goals, and these events are too important to risk landing on the wrong foot. Even in best-case scenarios, the absolute return over a short period rarely translates to much more than a marginal difference in your ability to fund your near-term goals.

Not saving in a tax efficient manner
The first move for people in their 30s and 40s should be a full Roth IRA contribution if their income qualifies under the current limits. Maximum contributions are relatively low, so the second bucket to fill with tax-efficient savings is your 401(k), if your employer offers one. Not enough people maximize the opportunity to save for retirement while minimizing taxable income in an automated fashion.

Enlightened Capital: We agree on aggressive asset allocation for individuals in their 30's and 40's, given where bond yields are now. In terms of optimizing taxes, I wrote about investment vehicles here, but I plan to write more on the topic to help my readers. As my friend points out saving in a tax efficient manner is an extremely important point to consider. 

2) What asset allocation would you recommend for someone retiring in 10 or more years?

I advocate for a strong overweight to equities in the current environment. With negative real rates across the yield curve and many areas of the fixed income universe flirting with their limits for capital appreciation (barring negative nominal rates, which is in unlikely path for the American financial system), the argument for fixed income as a source of portfolio returns is extremely weak. Moreover, low discount rates point directly to higher multiples, suggesting that what appears richly valued by historical standards in the equity markets will be fair, or even cheap, moving into the future. These concepts are more important for asset allocation today than many household investors realize.

Enlightened Capital: Please see my asset allocation suggestions here. My suggestions are in line with my friend’s recommendations.

3) In terms of life insurance, in what situations would permanent life insurance be the best choice a client

The phrase “buy term and invest the difference” has a nice ring, and those who repeat it usually suggest that anyone buying a permanent insurance policy has been misguided or suckered. Here’s why that shouldn’t be a hard and fast rule.

Firstly, the idea assumes an individual will, in fact, save and invest the difference. However, this doesn’t always occur, and cash tends to be consumed in current spending without a high level of dedication and discipline to an investing plan.

Secondly, it assumes the individual will invest the difference successfully. There are as many pitfalls to investing as there are in insurance product selection, so the proposition is no less daunting in most cases.

Where an individual has cash flow or a lump sum to dedicate to future goals, a permanent life insurance policy is an effective way to both 1) ensure a death benefit will always be available, AND 2) begin saving in a form that can be converted in a tax-efficient manner towards other needs should household circumstances change later in life.

Let’s examine the second benefit more closely, as this is often overlooked. Individuals and families can’t know what shape their life will assume in later years. Predicting what needs might arise or fade is very difficult, especially when thinking in terms of 30 years or more. Three relevant questions from an insurance standpoint, with unknowable answers, might be:

a) In what ways will their insurable needs grow or diminish?
B) Will they need or want additional sources of guaranteed income beyond Social Security?
C) Will physical or mental ability become a challenge in older age, and what burden might that place on spouses and family members?

A key feature of permanent insurance policies, which term policies do not share, is the ability to build cash value over time. This allows a policy owner flexibility if his or her insurable needs change or just become less important relative to other concerns. Such non-forfeiture options include:

1) Using cash value to convert to a paid-up policy where the owner no longer makes additional premium payments but keeps a lower permanent death benefit

2) Take the cash value and walk away, also known as surrendering

or the option I am highlighting here,

3) trade the policy in a tax-efficient 1035 exchange for either another life insurance policy with different features and benefits (see A above), an annuity contract (B), or a long-term care policy (C).

Without diving in the specifics of when and how a policy owner might decide between those options, the idea here is the tax-efficiency and flexibility of funding a cash value (permanent) life insurance policy while carrying a death benefit that won’t expire. If you had only bought term and invested the difference, you must fund these challenges (goals) separately and face an expiring death benefit at some point (hopefully!).

Enlightened Capital: While I continue advocating for term life insurance over permanent life insurance, it is helpful for my readers to hear some of the benefits of permanent life insurance compared to term insurance. Especially the behavioral considerations of investing the amount you save by purchasing term insurance over permanent insurance. Overall, I still believe term life insurance is the superior choice for most people due to the lower cost, the fact that most people don’t need insurance coverage for life, and the fact that permanent life insurance is not an efficient savings vehicle.

4) Are 529 plans the best vehicle for saving for college, or do you ever recommend saving for college with a Roth IRA?

While not an ideal primary savings vehicle, Roth IRAs are a useful supplement to 529s for saving for college. There is a strong incentive to not overfund 529s because withdrawals must be spent on qualified education expenses or be subject to a 10% penalty tax, as well as ordinary income tax on portions above basis. By intentionally under-funding the 529 and planning to compensate the difference with tax-free withdrawals of Roth IRA contributions, parents can minimize taxes and maximize flexibility. This is especially handy when the actual cost of college is unknowable until ~6 months before it begins. Of course, this strategy may impact retirement planning and a higher degree of coordination with your tax professional is recommended. And it is only available if your household income is below the Roth contribution limits for enough years in your advance planning to fund the account with any helpful amount.

The combination of features found in 529s makes them outstanding tools, and I recommend these accounts form the centerpiece of your education expense planning. These features include:

  1. Tax free growth
  2. The ability to fund early and often ($15,000/year per contributing adult to avoid federal gift taxes, $30,000/year for a married couple, and super funding limits of $75,000/$150,000/year as long as no other contributions are made over a five year period)
  3. 529 accounts can receive money from anyone, including grandparents, aunts, uncles, and even non-family members
  4. 529 funds can be spent on private K-12 education (up to $10,000 for per tax year)
  5. 529 funds can be used for education of the account beneficiary at any point in life, included grad school – there is no age limit
  6. 529 account beneficiaries can be changed and retitled without incurring gift taxes if the new beneficiary is a family member of the prior beneficiary, as in the case of siblings
  7. There is no AGI limit or income test for those making 529 contributions

The flexibility to fund and spend alongside the impact of tax free growth make these account superior for almost any household.

Enlightened Capital: I don't have any disagreements as we both agree that 529's should be the primarily vehicle for saving for college. The important point my friend brings up is contributing to a Roth IRA's give you greater flexibility in terms of how you can use the proceeds than a 529. See here for my suggestions for saving for college as well as my calculator to help you determine how much you should save on a monthly or annual basis. 

5) How should someone think about paying off student loans or other debt before starting to invest?

Student and consumer debt is of course an obstacle to achieving long term financial success. But it does not necessarily need to be cleared completely before investing. Here are three considerations to know if it’s time to take on the future instead of while you deal with past:

Amount of Debt
Having too much debt is makes you an unattractive borrower in the eyes of lenders. This may delay milestones like homebuying for years and set off a host of other challenges as young adults make their way through life. If consumer debt <20% of net income, AND if consumer debt + housing expenses (rent if you rent, or principal, interest, taxes and insurance if you own) <36% of gross income, most lenders should consider your debt load to be manageable. Irrespective of your homeownership status. I suggest these benchmarks are useful generally in understander if your debt is too much for your income.

Cost of Debt
The long-term equity risk-premium is somewhere between 6-8% depending on methodology. If you can invest and achieve annualized returns in this range while carrying debt with a weighted-interest rate of 5% or less, you are growing your net wealth with enough room to spare to justify the strategy.

Enlightened Capital: Here is one calculation of the equity risk premium, measuring the S&P 500 earnings yield (earnings/price) minus the real 10-year Treasury bond yield. Here is additional data on the equity risk premium

Yardeni equity risk premium

Source: https://www.yardeni.com/pub/stockmktequityrisk.pdf

That is of course the mathematical argument, but I also point to the immeasurable benefit of becoming an experienced investor, with the practical habits of saving and investing through time, as early as possible. The sooner you incorporate this, the easier it will be to build other financially productive behaviors and move towards your financial goals at a faster pace.

Savings for the Present
If both the amount and cost of your debt is not excessive, you should also shore up your emergency fund before investing while you carry debt. I recommend 6 months if you have no dependents or a mortgage. Something closer to 12 months is a better idea if your life has taken on some complexity and you are responsible for other people or major financial commitments. Should you temporarily lose income, this will help you make timely payments on your debt, keeping you in good standing with creditors and moving you toward the ultimate goal of shedding that debt. In short, ensuring your present before turning to the future.

If you have these criteria met, your runway to invest in a disciplined and diversified manner for long term goals, before clearing all debts, is most likely cleared for takeoff.

Enlightened Capital: I recently wrote about payoff debt early or investing the difference. The biggest difference in our answers, is that I'm more conservative when it comes to my expected returns for equities going forward. As a result, I would probably pay off debt with a lower interest rate than my friend would, to achieve that guaranteed rate of return. We have similar views on emergency funds, although I tend to advocate for 3-6 months of savings compared to the 6-12 months of savings that my friend describes here.

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