By Brad Thomason, CPA
How hard do you want to have to work to be able to retire comfortably? Did you know that a couple of things that you may be doing are having the net effect of making the job a lot harder than it has to be?
Most people find it a challenge to put back enough to get funding levels where they ought to be. And by 'ought to be,' that's not a measure of my opinion about where they need to be, but rather the mathematical reality of the inputs required to land in the win column. Just so we're clear.
Anyway, most people look at what they make and decide, consciously or not, that they want to spend as much as they reasonably can on this year's expenses. That's basic necessities and list of wants. Maybe a lot of wants. The remainder, by default, gets added to savings; and I think to some extent everyone begrudges, to one degree or another, having to set those sums aside for later.
Ideally, you reason, you want the machine to run on as little raw material as possible. This is one of the reasons that some people go a little zany over rates of return. It doesn't take much number crunching to realize that what is possible with 15% returns is a world of difference from what 6% will yield. Chasing big returns can lead to all sorts of problems. Planning on big returns that never show up can cause problems, too. But the point is, it's no mystery why we would want them. Among other things, they serve to justify putting in anemic amounts of capital at the front end.
Well, I don't really advocate for anemic contributions, regardless of the situation. But I will point out a couple of things you need to keep an eye on to keep the scales from tipping in the other direction. You don't want to be too stingy, but neither do you want to be shoveling in great scoops of capital that don't earn you returns or stick around for you to spend later on.
Where would such dollars go, you ask? To the tax man and your investment advisor.
Tax efficiency is a put-you-to-sleep topic if there ever was one. And yet, over the course of a lifetime, you could end up being impacted a lot more by taxes than you strictly, legally, needed to be. Like, six-figures worth.
The tricky part about the tax consideration is that we tend to focus in on the amount of the bill itself, and forget that there's more to it in terms of how the overall equation is impacted. Paying a dollar in taxes today is not the same thing as paying it in five years. That's because in the interim, the dollar earned returns. If you had paid it right away, those earnings would have never come into existence.
OK you say, but if I earned more money then my tax bill is no longer a dollar. It's more. True. But you make money 100 pennies at a time, and tax charges are less than that. So the difference you keep, even after the larger tax bill out in the future, is greater.
This is why IRAs and other qualified savings formats are so important, and part of the reason why the inherent tax aspects of annuities and rental real estate are frequently discussed. How and when you pay taxes will affect how much of the remainder you get to keep. A bigger pile of money that you pay a lower tax charge on means that you have to contribute less on the front end than what would have been necessary absent these factors.
The money you pay for investment advisory fees functions in a similar way. If you pay it out to someone else then it is not there for you to spend later, nor is it there to earn returns and compound in the interim.
Which is not to say that I have anything against investment advisors. I'm just pointing out that they can be pretty expensive when you factor in everything; and like any other item you choose to spend your money on, knowing what you can actually afford, matters.
If, over the course of 15 years, your account grew from $1 million to $2 million and you were paying 1% per year as an advisory fee, you would pay out north of $200,000 in fees. The effect on your portfolio would be the removal of the $200,000+, and whatever that sum would have been earning along the way. That earning loss wouldn't be just for the 15 years, by the way, it would extend out into the future, with the compounding effect serving to increase the ultimate cost every successive year that passed.
To wrap up, I'm not telling you to skimp on your principal contributions. I'm not even telling you to obsess over expenses. But I am pointing out that a couple of factors that you may not be thinking about too much are going to end up exerting some very material forces on your portfolio in the decades to come. As such, it would be best for you to decide just how much of that load you want to carry. You may come to realize that on your current trajectory, it's a whole lot more than what you ever realized you had volunteered to tote.
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