We’ve been aggressively saving money for the past few years, specifically after discovering financial independence (FI). Not only are we putting aside a large percentage of our income each month, but it’s important to make sure that money continues to grow, particularly in a safe, long-term fashion. The places that we invest our money in today will determine both how long we need to continue working full time jobs, and what kind of lifestyle we’ll be able to live once we walk away.
Upon starting our first real jobs out of college and entering the adult world, the only standard advice out there seemed to be “set aside 10-15% for retirement” and “be sure to max out your employer’s 401k match”. The 401k part was easy and we set up that 2-4% investment right out of the gate, but the other part just kind of happened naturally as we adjusted from a cheap college lifestyle into the world of real paychecks. Unfortunately, the money accumulated via this natural frugality pretty much just sat around in a checking account without any purpose, and we would slowly take chunks out of it for new furniture, trips, and other miscellaneous purchases.
Luckily we didn’t inflate our lifestyles too drastically before stumbling upon FI and a real purpose behind setting aside that extra money, the ability to buy our freedom! Once we realized retiring in our 30’s was achievable, it didn’t take long to start looking a little closer at our investments. After reading a ton of material both online and in books, it turned out that the most consistent, long-term performing investments also seemed to be the absolute simplest! By spreading our money over the entire market via index funds, we could simply ride the average growth across all businesses and industries around the world at a very low cost. I’ll break down exactly how we execute that strategy both inside and outside our retirement accounts, adding money monthly, and setting ourselves up for a potential early exit from the 40-hour per week working world.
The Strategy – Low Cost Index Funds
If there is one consistent truth across almost everything I’ve read about investing, it’s that you almost certainly can’t beat the market. “Almost certainly” leaves a little to the imagination as there is always someone you can point to that did it, but the overwhelming amount of data indicates that you specifically will not. For every person that pulled it off, there are many many others who managed to under-perform.
One of the best market beaters alive, Warren Buffet, issued a “million-dollar bet” directly challenging hedge funds to beat the market over ten years. “The market” being Vanguard’s low cost S&P 500 index fund. Nine years into the ten year bet, Buffet is currently way ahead. Keep in mind that the competition here is huge hedge funds armed with a crazy amount of resources and information that isn’t even available to the average investor! How can anyone expect to compete on this playing field with the occasional glance through the latest market headlines?
Lucky for us, you don’t have to try to beat the market yourself and can quite literally just join it. The idea was considered a bit crazy decades ago, but now almost every reputable investment firm offers funds that simply attempt to mirror the market by owning every stock in it. No fund managers to make decisions (or mistakes!) or analyze data in order to choose whether or not to buy or sell, and no reason to pay them outrageous fees to do so. Owning the market in equal weight to the size of each part of it is so simple that most of it can be automated, bringing the cost of actually participating down to rock-bottom levels.
Vanguard was the first to offer these types of low-cost index funds, but now they are prevalent across most major companies. Charles Schwab and Fidelity are frequently competing with Vanguard to have the absolute lowest percentage cost for each fund, but at this point they are all viable options. One notable exception is that Vanguard is owned by the funds themselves (which are in turn owned by you), whereas most other companies primary goal is to make a profit off of the investment holders, often by encouraging them to unnecessarily “diversify” out of these low-cost funds into more actively managed options. The “funds owning the company model” helps minimize the chances of conflicts of interest potentially costing the customers (you) any extra money in fees.
That is the main reason we stick to Vanguard, but a disciplined investor should do just fine with the equivalent funds in several other investment companies.
Alright, so that explains the basic philosophy behind the choice of index funds for our investments, but let’s look at how we actually put that in practice.
The 7 Accounts That Hold Our Investments
In an ideal world, we would put all of our excess cash into a single account and would own the 3 different funds that make up our 3-fund portfolio (which I’ll explain more of below) in the exact ratio we determined works best for our goals. Unfortunately, that is far too simple of an approach if you want to get the best return for your dollar. The main reason being the various tax-advantaged accounts that we have access to that save us a serious amount of money. These include IRAs, 401ks, and HSAs between the two of us.
By channeling money through these different accounts, we are able to save a lot of money on taxes, both now AND in the future. In fact, a good percentage of the money we defer taxes on now, while in the earning phase of our FI journey, can potentially be withdrawn later without any taxes being paid on it! This is thanks to the number of “in-between” years that fall between the time we “retire early” and traditional retirement age where we can take advantage of things like a Roth Conversion Ladder.
The List of Accounts:
- Noah’s 401k
- Becky’s 401k
- Noah’s Traditional/Roth IRA Combo
- Becky’s Traditional/Roth IRA Combo
- Noah’s HSA
- Becky’s HSA
- A Shared Brokerage Account
The 401ks are pretty simple and are set up through our respective employers. Each offers a moderate match and we choose to go beyond that by deferring the maximum amount possible out of our paychecks, $18,000 per year per person. These contributions and the matches end up as tax-deferred holdings in a Traditional 401k account. In theory, we will owe taxes on the money when it is eventually withdrawn, but thanks to the standard deduction and personal exemption during our non-working years, we can potentially avoid paying any taxes at all. Also, this money is theoretically “locked up” until we are 59½ years old, but there are a couple ways to access the money early and penalty free if necessary.
The HSAs are also pretty simple and are again set up through our respective employers. Both employers put in a fixed amount of money at the beginning of each year and we are free to max out the remaining allowed amount up to $3,400 per person directly out of our paychecks. Once again, this money is tax-deferred but has the additional benefit of also avoiding FICA taxes upon entry. The HSA is also different in that money can be taken out penalty and tax free for medical expenses, or treated like any other Traditional retirement account after the age of 65 (owing taxes on anything withdrawn). Both of our HSAs allow us to invest the money in the account, so we currently chose to pay our medical expenses out of pocket while letting that money grow tax-free.
The IRAs are a little more complicated because we are in the fortunate situation of making too much money to contribute to them directly for any benefit. Thanks to a well-known loophole, known as the “Backdoor Roth IRA”, it is still possible for us to each get money into a Roth IRA each year. By placing post-tax money into a Traditional IRA, then rolling that money over into a Roth IRA, we essentially get the same benefit one would by contributing directly to a Roth IRA. Be sure to research a little before trying yourself, it gets a little complicated and messy if you have more than $0 already in a Traditional IRA. Each year, we move the maximum of $5,500 per person into our IRA. As this money ends up in a Roth account, we’ve already paid taxes on it, but will be able to withdraw it and any gains in the future completely tax-free. Gains on the contributions are pretty much locked up until 59½, but the contributions can be taken out earlier for no penalty.
The Shared Brokerage Account is the catch-all for any extra money we have that we want to invest. There are no tax-advantages to using this kind of account, so that’s we make sure to fill up all of the above accounts first, but it does have the advantage of simplicity and no caps. Any money in this account can be withdrawn at any time for any reason at any age with no fees or penalties of any kind. The money invested in this account has already had taxes paid on it, but we will potentially owe additional taxes on any gains that are withdrawn in the future. Once again, any years between early retirement and traditional retirement age are a good opportunity to access these gains tax-free thanks to a 0% capital gains tax for lower incomes.
Having 7 different accounts makes things a little complicated, but it’s not too hard to manage. The accounts themselves are simply containers for our investments, so now we should take a look at what investments we actually fill those containers up with.
Our Target Investment Allocation
As I detailed above, our investment strategy is based around low-cost index funds. There are a few different ways to invest in these types of funds, the simplest being an indexed “Target Retirement Date” fund. This is usually my go-to recommendation for someone who asks me what to invest in because they are extremely simple. It’s a one-stop shop that encompasses the entire world market, automatically rebalances, and slowly adjusts to a more conservative asset allocation over time. You simply pick the year you plan to retire, throw all of your investments into that single fund, and there isn’t even a third step!
We then take the same approach one step further by looking at what the target date fund invests in and copying it ourselves across the same underlying funds. This saves us a small amount on fees and also opens up the potential for tax-loss harvesting, but otherwise is an almost identical approach. We trade off a small amount of work to save a small amount on fees, but I would understand if someone were to take the opposite approach in the name of simplicity.
If our goal is to copy these target date funds, let’s take a look at one. Specifically, let’s look at Vanguard’s 2050 fund (VFIFX):
As you can see, VFIFX simply holds 4 of Vanguard’s core index funds in different percentages and carries an expense ratio of 0.16% on invested funds. Our approach is to simplify this slightly by removing the small percentage of International Bond holdings and sticking to the old-school Boglehead 3-fund Portfolio. The International Bonds will be replaced with more US bonds and for no reason other than ‘Merica, we also shifted a little heavier towards US Stock versus International Stock.
That makes our goal asset allocation:
- 60% Total US Stock Market
- 30% Total International Stock Market
- 10% Total US Bond Market
The 5 Funds in Our “3-Fund Portfolio”
Similar to the above reason of why we have 7 different investment accounts, we also have more than the 3 funds that are necessary in our goal asset allocation. This is because each of the different accounts has access to different funds. While our IRAs and brokerage account can be invested in just about anything, each of our 401ks and HSAs are more restricted in investment options. Luckily, they each have appropriate funds that match our target allocation and have low fees, so we simply have to slice together the right combination.
Initially, I simply attempted to replicate the 60/30/10 investment split in each account, but this proved to be inefficient over time. Our tax-advantaged accounts all offer free trades that don’t trigger any taxable events, but once we were able to add additional funds in a brokerage account, this “fund-swapping” was no longer possible with any efficiency.
At that point, I evaluated the different fund options in each account and set a goal dollar amount for each of our 3 assets based on the total amount we had invested at the time. Add in a little tax-efficient fund placement theory (which is beyond the scope of this post, but you can read about HERE if interested) and this is the split we ended up with:
- Total US Stock Market Funds – 60%
- Total International Stock Market Fund – 30%
- VTIAX – Vanguard Total International Stock Market Index Fund – 0.11% expense ratio
- Total US Bond Market – 10%
- VBMPX – Vanguard Total US Bond Market Index Fund – 0.04% expense ratio
You’ll notice that a portion of our “Total US Stock” allocation is in an S&P 500 fund which only tracks the top 500 companies in the US rather than the entire market as a whole. Those top 500 companies do currently comprise ~80% of the total market, and there is no shortage of articles comparing the two options against each other. The jury is out on which approach is better (S&P500 vs. Total Market), but pretty much everyone agrees they are very close and the historical performance matches that conclusion. We only chose this particular S&P500 fund because there wasn’t a comparable total market fund in the specific 401k, and it’s hard to beat that 0.02% expense ratio!
The selection of Vanguard for most of our funds was partially a choice and partially what we had access to in our respective tax-advantaged accounts. As mentioned above, I prefer Vanguard to the other big firms due to the ownership set-up of the company, but a disciplined investor would do just as well with the low-cost index offerings of Schwab, Fidelity, or other similar firms.
As you can see from our expense ratios above compared to the expense ratio of the comparable target date fund (VFIFX at 0.16%), we are saving a moderate amount by doing the underlying allocation ourselves. Even the most expensive fund we own (the International Stock portion at 0.11%) comes in under the target date fund, while some of the other options come in much much lower.
According to Personal Capital (which we use to track our investments across all of our accounts), the current overall expense ratio across all 5 of our funds across all 7 accounts is 0.06%. Therefore, the benefit of taking the DIY approach versus the target date fund approach is ~0.10% per year. According to an expense ratio calculator I found via Google, this will amount to a difference of ~$68,000 over the next 30 years!
If a small difference of one tenth of one percent adds up that much over time, imagine how much funds that charge 1% or more are making you lose out on! If you don’t know what the expense ratio of your current investments are, then go check them now and get out of anything above 0.50%, ideally switching to something 0.20% or lower if available.
How We Add Money Going Forward
Now that everything is moved into our target asset allocation, how do we maintain that ratio going forward?
First, I took care of the auto-investments. Between our 401ks, HSAs and the employer matches, over $40,000 is automatically going into investments from our paychecks throughout the year. In order to match our 60/30/10 split, I figured out how much was going into each account and chose the respective funds to match our overall asset allocation. For example, I might have one 401k covering all of the desired bond split with the rest going into the total US market. The other 401k could then put the bulk into the total US market, with some going into a total international fund. The HSAs can then top off the international allocation to the correct amount.
This isn’t exactly how I have it set up (considering tax-efficient fund placement again), but hopefully you get the idea. It’s important to look at all of your investments across accounts when determining how to invest. There is no reason for each individual account to have it’s own asset allocation, it’s the overall picture that counts.
We can then use the semi-monthly contributions to our brokerage account (which I still do manually) to balance out or top off whatever fund is necessary to get closer to our ideal allocation. The primary goal being to avoid selling anything in the brokerage account and triggering a taxable gain, while still maintaining our overall asset allocation. The free trades in the tax-advantaged accounts help with this greatly and should make re-balancing easy so long as they stay a large percentage of our overall investments.
Our investment strategy is now open to the world and you are free to copy it if desired. We aren’t trying to re-invent the wheel or beat the market, but instead just plan to ride the steady wave of the market upwards over the long term. There’s no doubt in my mind that the market will crash at some point (it always does), but that doesn’t change our investment strategy at all. “Time in the market beats timing the market” as they say. Most of our investments are automated thanks to contributions out of our paychecks which makes things really easy, but we’ve also been disciplined in pushing our extra cash flow into the brokerage account each month regardless of what the market is doing.
Even when the stock market inevitably does a bunch of weird stuff (both up and down), we’ll continue to push money in month after month without paying too much attention. This has been the tried and true investment method that works best over time and we plan to stick with it. Many investors lose the most when they panic-sell in a downturn and I hope we have the fortitude to stick to the plan through whatever might come our way in the future.
Hopefully you can stick to your investment plan too!