Where Should Your Extra Savings Go?
Marcus Schafer (00:17)
This is going to be episode 33, the double triple with Pat Collins and Marcus Schaeffer of Greenspring Advisors, where we’re going to talk about what is the next best use of your extra dollar of savings. So if you make more than you spend, probably a good habit to get in to get in the habit of.
What do you do with that extra dollar? How do you optimize that extra dollar of savings? What are all the decisions you should be thinking through? And then maybe what are some things that you don’t have to overthink? Pat, I’m excited to talk about this. I think it’s one of the top questions we get from ⁓ people just all the time.
Pat Collins (00:59)
Yeah, I agree. This is going to be an episode, I believe, heavily around tradeoffs. Obviously, when you have an extra dollar, there’s tradeoffs of you know, ⁓ investing that money or paying down debt or pay tax now or pay tax later or putting in a cash reserve or investing it for the long term. So there’s all these different tradeoffs that I think we’ll get into. But that’s going to be the primary kind of gist or maybe underlying.
of this podcast is gonna be thinking through these trade-offs that you have when you do have money to invest.
Tightwads, Spendthrifts, and the Pain of Paying
Marcus Schafer (01:34)
You speak about those trade-offs. One of things I was reading about in advance of this is research that kind of buckets people into these two categories, ⁓ tight wads and spendthrifts. And essentially what they were doing is they were looking at how spending money ⁓ triggers pain responses in your brain. And some people just seem to be wired where spending money is more painful than other people. for some people, think some of these conversations are, hey, how do you
How do you actually get to spending a little bit more money? How do you understand what you could achieve in the long term? And hey, you might actually value spending more money in the short term. ⁓ It might be worth it more to you because you’ll have too much money later on. And then there’s another group of people that ⁓ they just don’t feel the pain in the same way. So it’s harder to get that delayed gratification. maybe towards the end, we could talk about
different frameworks to actually set the right, how do you order your cashflow coming in to make the best use of it?
Savings Rate Comes First
Pat Collins (02:40)
Yeah, and even before we get into what to do with that extra dollar, I think it really is important point to think through is this is just my belief is that the number one part of planning your financial future, if you had to focus on one thing, it’s gonna be cash flow. It’s going to be, I spending more than is coming in or spending about the same as what’s coming in? And if.
If that’s not right, nothing is gonna work. no tax strategy, no investment strategy is gonna get you out of a massive savings deficit. So I think it’s really important for people to start with this very basic framework is, what am I saving every month? What am I saving every year? Our belief is that should be, and we’re talking about in the accumulation phase of kind of your life, so pre-retirement. But our belief is that that needs to be at least 10 % of your income. So if you’re making,
$300,000 at a minimum when you add up all your different savings vehicles, it should be $30,000. That to us is kind of the minimum level. It probably should go up from there. And that does two things. One is it allows you to have this margin to talk about the things or do things that we’re going to talk about today, which is how to save this money. But two is it shrinks the amount that you need to be financially independent. If you spend every single dollar that comes in, you need more money.
to be financially independent than if you’re saving 30 % of your income because you have a smaller amount that you need to recreate when it comes to kind of spending in retirement or spending when you’re independent. So I think it’s a good first step for everybody is making sure that their budget is in a good spot. And obviously we’ve talked about this in the past and this could be a future podcast episode. We’re gonna talk about once your budget is okay, what are you doing with these dollars that you’re saving?
Marcus Schafer (04:29)
Fun fact, well, I guess maybe not so fun, but Goldman Sachs just studied 5,000 kind of individuals and participants. And one of the things they found, Pat, was that more people that make over $300,000 feel like they’re living paycheck to paycheck and not able to make progress towards their greater goals than people making less than 100,000.
Right? So it’s this really weird thing where 40 % ish of people making 300 to 500,000, 40 % ish of people making 500,000 plus, they feel like they’re living paycheck to paycheck at the same rate as people making 50,000 to 100,000. And actually there seems to be a sweet spot of people making 100,000 to 300,000, where only 25 % of those people.
feel like they’re living paycheck to paycheck compared to making progress. And it’s just really interesting where sometimes you think, hey, maybe because I’m making more income, I don’t have to really think about that budgeting conversation. But it seems that it’s kind of pervasive across all income levels.
Pat Collins (05:41)
It’s so easy to to see lifestyle creep come into your kind of into your financial lives Whether that means upgrading your house upgrading your lifestyle travel more you have you know Expenses related to you know leisure entertainment you join a country club you buy a boat all these things you buy bigger cars all these things are just so easy to kind of see creep up and so you know our belief is you kind of start with
the savings component, which is figure out how you’re going to save 10 % or 15 % or whatever your target is, and then just figure out how to live on the rest. again, as people’s income goes up, obviously, like the study shows is that the expenses are gonna go up. So as much as you can fight that, we think that there’s some value in it because I’m not sure there’s a tremendous amount of incremental happiness that comes from increased spending. At least that’s what a lot of the research shows.
is that those making three, four, 500,000 are way more happy than those making one to $200,000. It doesn’t bear, and I don’t know about you, but I’ve seen that in my life too, where I can think about when I just got out of college and was making no money. I don’t think my level of happiness has changed significantly from then to there. So I think there’s other things that go into kind of quality of life and just how much income you’re making and what you’re spending.
Make the Plan Automatic
Marcus Schafer (07:09)
a lot of people used to maybe talk about how you reflect on your college life. Type one versus type two fun, right? Type two fun, definitely fun to remember about maybe having some nicer things in the moment would have been great. But let’s jump forward, all right? So we’re making money, we’re spending less than we make, so we have some excess cash coming over. And I think there’s kind of like two buckets where you see this
kind of excess cash come in. One is going to be kind of monthly, right? So how are you thinking about that? And then the second is kind of these bigger kind of bonus payments. And then we have people asking us questions kind of both, hey, just from a system standpoint, how should I be thinking about where my extra money goes? And then also from this bonus standpoint, where should my extra money go? So when they ask us that question, Pat, what do you think is the first thing that you would tell people to
to think about.
Pat Collins (08:09)
It’s an easy one, it might be a little boring, but I always think you start with a plan, which is to just, it’s almost an organization of your thoughts of what is it that you want to accomplish in the future? Are you going to be buying us another home in a few, you know, in a year or two? Do you have major upcoming expenses? When do you want to retire? When are your kids going to be going to college?
There’s all of these competing interests for the for your dollars, for from a resource standpoint. And we all have limited resources. Every single person on this planet, even Elon Musk, has limited resources in the sense that there is some limit on what we have. I think that’s number one is trying to really figure out where you’re starting from. You know, what are all your kind of assets that you have, your liabilities, your income, your expenses, and then trying to really codify what are the things you want to accomplish, because that’s going to direct
or should direct a lot of your savings and where you save and the types of vehicles that you save in. If you want to retire early versus you want to retire at 70 or you don’t want to retire at all, that’s going to change a lot of the kind of recommendations or things that you should be thinking about when it comes to that next hour. So first and foremost, whether you do it on your own or you work with your advisor to do it, have a plan.
get an idea of what kind of your cash flows are going to look like over the next several years.
Marcus Schafer (09:31)
The other thing that helps you do is you can prioritize, but a lot of times I think that leads to people understanding, hey, a goal of mine, it is a priority, but I really don’t have to think about it now because if I think about what my cash flow is going to be like in the future when maybe that goal comes up, maybe I’m going to have more cash that I could dedicate at that point of time. ⁓ So it’s kind of thinking about, hey, what are these different
What’s your situation? What’s your cash flows? What are those like over time? ⁓ Tough part is everybody’s cash flow looks great in theory. And as we all know, when you have great cash flow, want to spend it. Helps you prioritize those goals over time and then try to match when you should be saving for a specific goal. ⁓ What do you think about a lot of the
the software that people might use like budgeting apps and things like that. has goals and it really encourages you to save a specific account for a specific goal. I don’t know your thoughts on kind of the mental accounting framework.
Pat Collins (10:39)
I the mental framework is really positive. think people like to see progress when they are trying to save for a goal. So if you just have it in one bucket, sometimes it’s hard to kind of say, I on track or how far? Because I know that this bucket that is going to be all of my spending over the next five years, for example, I know there’s so many different competing interests for it. So I don’t really know if I’m on track or not, but it feels like I see it going up. is it really, you know, so.
I do like the idea of at least in principle on segmenting kind of your goals into different buckets. I think that’s really important. I also want to go back to something you said, which I think is really good one, because we do hear it a lot, which is I’ll use an example. You know, I’m making a million dollars a year. My kids go to college in five years. I don’t really.
need to worry about saving for college because we can just pay it out of cash flow. It’s not really that big of a deal. And I think an important thing to think through and that may be true, but we have to think about the certainty of income continuing and the certainty of margin and excess continuing into the future and how much you want to rely on that. So if it’s reliant on you having a job at XYZ company, is there a chance in five years you could lose your job? Of course there is. Or maybe you own a business
Is there a chance there could be a downturn in your industry that could really cut things out? So I do think that that’s really important is not to just project the current present tense into the future and say there’ll never be any changes to this. That’s part of the reason why saving is important is it does give you some optionality. If you’re wrong, ⁓ OK, great. You have a lot of excess cash flow at that point. But if, you know, if for some God forbid reason you did lose your job,
at least there’s some plan or some sort of ⁓ contingency if something like that were to happen.
Marcus Schafer (12:37)
You bring up a great point in terms of the further out of time, the less certainty you have of that thing actually occurring, know, college to use your example. Hey, what’s college going to look like in 18 years? What’s your career going to look like in 18 years? Those are all really big questions. And it does kind of juxtapose the benefits of mental accounting, being able to see progress towards your goal with
Hey, if you’re saving in something like a 529 plan, which is kind of specific to that goal, you’re losing optionality. If that’s the framework that you decide, which means, hey, in 15 years and 10 years and five years, if the goal’s not the same, your money is kind of a little bit trapped in something like that. And it’s not the end of the world, but it’s just ⁓ the counterbalance to the benefits of mental accounting.
The Savings Waterfall
Pat Collins (13:35)
Yeah. And I think just going back to something we were talking about just a few minutes ago, I think if you turn the podcast off now and all you learned was I got to figure out a way to make sure there’s margin in my in my budget, that I’m saving dollars every single month. I think you get like 80 percent of this right at this point. What we’re probably going to talk about next and for the remainder of the podcast is how do you optimize that? How do you get that so that you’re getting the biggest bang for your buck?
for each dollar that you’re saving. And so some of that’s going to be, you know, we’re going to talk about kind of tax optimization or talk about investment optimization. But also, I think there’s a risk element to it that we want to talk about as well. So maybe just thinking about that next dollar now, let’s just kind of get to the point where we have are starting to save and we realize we have excess dollars to save.
This is just a framework I use and I’m not saying it’s right or wrong, but it’s something that’s helped me over time. And I think about kind of this cascading bucket theory, which is if you can think about buckets stacked on top of each other, when you fill one up, as soon as it gets filled up, it starts to pour over the sides and that goes into the next bucket basically. And then the third bucket. And I basically have it, I think through it in essentially two big buckets.
So one of the things that I would consider to be like either low hanging fruit or like risk management issues. So the things for me is that I want to, before I do any of the second bucket, I want to make sure the first bucket is completely filled. For me in that first bucket is ⁓ maintaining a cash reserve. So I want to have enough cash on hand so I can meet any emergency that comes up. Everybody’s got a different number here. Maybe we’ll talk about this, but I think it could be anywhere from
two or three months of expenses, all the way up to a couple of years of expenses if you have massive variability in your income and lots of big expenses that can come up. So that’s number one. The other thing in that first bucket for me is high interest debt. If you have debt that you’re paying 15, 20 % on, get that paid off before you do anything else. And then the third thing in that bucket for me is free money. Is there anything that if you invest, you are getting some sort of match associated with it? Obviously 401k is probably the most
the most common thing that you intended to focus on here. But you also see it with things like like HSAs and things like that, companies can match. So just making sure you’re filling up that bucket first before you do anything else, in my opinion, is probably one of the more important things to do is get those foundational things right before you get into any of the other things that we’re going to talk about.
Marcus Schafer (16:21)
Yeah, and maybe those foundational things, if you just kind of think about excess money, even that’s, hey, making sure your insurance is right. That might be a better use of your next dollar of income is saying, hey, I, you know, for you, you own a lot of a small business. Does that mean that you need to take out extra insurance and that’s the best use of that dollar? It might. So trying to get all of those short term things. All right.
Liquidity, Taxes, and Account Flexibility
Let’s talk about that next bucket. Probably one of the biggest goals people are saving for long-term is retirement. ⁓ Kind of two ways you could probably think about it. And that’s, you’re putting money in a tax advantaged account, which is illiquid, or you’re putting money in a taxable account, which is liquid. Now, interesting study here is ⁓ some researchers have looked at
whether or not people like illiquidity or not. And it turns out that some people actually like illiquidity and they’re willing to invest more if it’s illiquid. They’re willing to accept lower returns in some case if it’s illiquid. And I think that’s because it’s going to kind of force savings behavior, right? You know, hey, retirement’s a really long way out. I can’t touch this money, so I can’t derail. can’t…
be self-destructive in any way. there are mechanisms to access tax-deferred money, but you definitely have to jump through some hoops to get to them.
Pat Collins (17:57)
Yeah, it’s really interesting. I’ve seen this play out in real life, too, where someone may look at an account statement and say, I’ve got $4 million sitting in this IRA account. ⁓ If I needed, I could access it. And if something does come up, they may give us a call and say, hey, I need to take out $100,000. And when you tell them, it’s not that it’s entirely a liquid, but
It feels that way because when you tell them, oh, to get 100,000 MEC, you’re going to need to take out 200,000 dollars because of taxes and penalties and whatnot. Almost always they say, well, I don’t want to do that. That sounds crazy. there is something to and so long story short, there may be some value to it in the sense that, you know, maybe it stopped them from buying that, you know, the boat or whatever it is that probably was may not have been a well thought out purchase. So
So yeah, I think there’s some, it’s interesting that there’s even a preference to it. Cause if you ask me rationally, I would say, I would expect higher returns if I had to give up liquidity. That would be my preference as an investor.
Marcus Schafer (19:09)
What the research did was it looked at different scenarios and it kind of assessed the penalties, right? And it used penalties that at first blush are kind of common with 401k and IRAs. And that’s like the 10 % penalty. And then it said, okay, well, how much are people willing to bucket to distribute in these two buckets, one with a penalty, one without. And the more they increase the penalty, you actually saw more assets going towards the illiquid.
⁓ investment to the point where when they said, hey, you actually can’t touch it at all. More than half of the assets people were kind of choosing to go in that direction, which kind of flies in the face of optionality. But that’s if we’re robots and we aren’t robots. Right. So I think there is that benefit between for for savings. The downside is you get somebody really young and common conventional wisdom is, hey, max out your 401k.
And then you become closer to my age, the age that your kids are going to be moving up into where it’s like, okay, well, I want to buy house. I want to do all these things and good news. I’m ready to retire. Bad news is it’s 40 years away.
Taxable Brokerage vs. Retirement Accounts
Pat Collins (20:26)
It goes back to what we talked about in very beginning, which is you want to start with a plan because, if you’re planning on retiring at 55 and you were just maxing out your 401k, that’s probably not the best use of your next dollar or at least not the full dollar should be going into that 401k because it’s not being thought through as to what am I going to do in this intermediate term of five years.
that I don’t have access to this capital, this pool of money. I think there’s, ⁓ if you’re talking about retirement, there’s basically, and you’re saving, I think there’s kind of, obviously there’s more than this, but three big buckets to think through, which is, I want to save in a taxable account? Which means, there’s pros and cons of that. Pros is, and again, we’re going to go back to trade-offs. ⁓ The pro is that I have complete flexibility, liquidity,
⁓ I can get access to this whenever I need it. The con is, is it’s probably the worst from a tax perspective. ⁓ I’m going to have to pay taxes ongoing on the dividends, the interest, the capital gains. When I retire, obviously when I pull the money out, I’m going to have capital gains taxes on that. ⁓ Then you have the other options within say an IRA or 401k, which is I can go pre-tax, which means I get a deduction by contributing money to that account.
And then when I take the money out, I have to pay ordinary income taxes on it. So pros are tax benefit currently today. If I’m in a high bracket, there’s some benefits to that. The con is, is that when I take the money out, it’s gonna be worth less. I gotta pay taxes on it. So when I look at my statement, it says a million dollars in a 401k, it’s not really a million dollars. I can’t spend a million dollars. It’s a million minus whatever my taxes are going to be on it when I withdraw it. And then the third is the Roth, which is… ⁓
You know, I get I have to pay income tax now ⁓ on any money that I put into it ⁓ or or I don’t get a deduction, I guess I should say. But when I take the money out in the future, it’s tax free. So if I’m in a high bracket later, it’s really valuable because I can avoid paying taxes then. So that’s a lot. But so there’s all of these competing interests and there’s pros and cons to each of them. And you really have to think through your current situation, your future situation and your goals.
to really figure out which one is best. It’s hard to say with kind of like a, just kind of a rule of thumb, this is what everybody should do. And we have a whole episode on kind of, ⁓ you know, kind of thinking through some of these tax considerations. But I do think, you know, starting with a plan, thinking through where you’re going to be, all these things are really important.
Marcus Schafer (23:10)
And the interesting thing about taxable accounts, you mentioned some of the downsides is paying along the way and then paying when you sell. And the good news is paying along the way, it’s actually gone way more efficient compared to the last 10 or 20 years. If you were thinking of active mutual funds, those might be causing a drag of one or 2 % or more per year.
just from taxes, not from the higher fees, from the investment. ⁓ Science has improved a lot of that stuff where like tax efficiency has gotten way better. ⁓ So I think that’s a change that’s maybe happened that if you’re not keeping up with things, ⁓ might make those accounts more appealing. And then the other thing you were talking about is, how do you really think about
your tax situation today and the unknown about what do we think your our tax situation is going to be in the future. And the tighter that time horizon is, the way more accuracy you can have and making that decision, right? Like if you think you’re going to retire in two years, you’re way more confident about your strategy over the next three years than somebody like ⁓ like me where
If you look at tax rates over time and how they’ve changed for somebody in your tax bracket, they do fluctuate really dramatically. So you really have to think about, what is my tax bracket today? Federal and state, I think is an important consideration that gets left out a lot of times, ⁓ particularly if you live in one these higher tax states. ⁓ And that’s going to help you make that determination. ⁓
For most people, they drop in tax brackets when they retire relative to peak earning years. So about 40 % of the population was in the top four tax brackets before retirement. When they retire, about 20 % of those people stay in those top four tax brackets, which gives you some idea that there does seem to be this retirement income valley that ⁓ we talk a lot about.
Pat Collins (25:29)
It’s really interesting. And I think one of the things that all of us should kind of take to this process is a degree of humbleness that we don’t know what the future is going to bring. And I think you’re absolutely right. I always tell clients when I’m talking to them, we every year before, if you’re retiring and that’s one of your goals and every year prior to retirement, we get a little bit more clarity around what your investment situation is going to look like, how much you’re going to have in assets, what your tax situation is going to look like.
what your expenses are going to look like, because, you when you’re 35 or 40, it’s really hard to predict in 30 years what things are going to look like for you personally. Even take the economy out of it, just where you’re going to be living, what you’re going to be, what your expenses are going to be. So I do think that’s important. And with that, I believe that an all or nothing approach to this kind of savings that we’re talking about, which is
how much should I put in taxable accounts? How much should I put in Roth ⁓ 4.1k, pre-tax 4.1k? The idea that all or nothing, ⁓ obviously, it can work if you get it right, but it’s like stocks and bonds. ⁓ A lot of times, we don’t want to put all of our money and all of our eggs in one basket, and we say the same thing about taxes.
With that being said, the way I like to think about is more probability based. So if I say, well, I think realistically, there’s about two thirds of the time I’m gonna be in a lower bracket in retirement than I am gonna be now. I don’t know, I know it’s hard to say, this is gonna be somewhat guesswork, but maybe a third of the time there could be either, I just crush it in income, I have a lot of assets when I retire, I’m gonna keep me in a high bracket or.
Maybe a third of the time we see rates go up, tax rates go up because the government is in a deficit and that could happen. So that’s kind of how I think about just, you know, it’s a simplistic way to do it, but that’s how I think about how do I balance my next dollar of savings. I might say, well, maybe two thirds should get a pre-tax because I think it’s most likely, maybe two thirds of the time I’m gonna be in a higher bracket today than in the future. And then about a third I’ll put into post-tax or Roth or maybe even, you know, brokerage account.
because I think I’ll be in a higher bracket in the future. So it’s not perfect, but I mean, think that’s something to think through and maybe even something to talk with an advisor about is, you know, how do you think through those decisions?
Roth vs. Pre-Tax Is Not a Religion
Marcus Schafer (28:00)
When you’re talking about the benefits of talking with a third party, I think about when you happen to be paying the most taxes, how much does that cloud your perception about what future taxes are going to be? Like, hey, if you’re paying 50 % in taxes, you feel a lot of pain. That might lead you to think, man, tax rates are going to be 50 % in the future because this is the world we’re living in. We all know that.
And that might encourage you to say, actually, I’m concerned tax rates are going to go up more than maybe is likely. So I want to do a Roth contribution, which is kind of in peak earning years. And you might say, that might be a good spot to have somebody check you. I looked at some research and it modeled things out. I was thinking if I could show the visuals, but they’re so confusing that I don’t think they would help anybody whatsoever.
but I will share the summary, which was a rule of thumb. Essentially, if you were in a 10 or 15 % tax bracket, it probably makes sense to allocate to Roth. In general, this is not specific. For ⁓ most people, the recommendation was age plus 20%.
goes into pre-tax and the rest goes into Roth. So if we think about that from my perspective, 35 years old plus 20%, that’s saying about 55 % of the money should go in pre-tax and the rest in Roth to try to get some of that tax diversification, knowing we don’t know exactly what’s going to happen in the future, which conveniently actually I think kind of matches up
to where a lot of company matches happen to be, right? You could say, well, the match is gonna be pre-tax, so why don’t I contribute to a Roth number? And it ends up being about that ratio. How do you feel about age plus 20 %?
Pat Collins (30:12)
I think it’s not bad. I actually think it’s a good framework. And I just think there’s so much uncertainty with it that what it does is it really does create tax diversification. Nobody knows. It’s the same with asset allocation. If you tell me what the future is going to hold, then I can tell you exactly what my asset allocation is going to be. And same thing, if you tell me what the future is going to hold with tax rates and your income, there’s even more.
variables when it comes to which vehicle to save in, because not only do you have the external where tax rates going to be, similar to where the market’s going to be in the future, stock market, bond market, and whatnot, but now I have my own personal circumstances I have to pull into it, which are probably just as or more important, which is when am I going to retire? What’s my health going to be? What’s my income going to be? What’s my asset base going to be? There’s so many variables that go into this.
Just that having that framework to create some level of diversification, giving you optionality when you retire. I think it’s as good as any. Let’s put it that way.
Mortgage Prepayment vs. Investing
Marcus Schafer (31:20)
jump to another big conversation I think we often have, which is, so I have some excess cash, should I invest it or should I prepay my mortgage as a consideration point? ⁓ That’s another one that comes up a lot. And there’s a lot of, I think, psychological benefits to being debt free. So maybe just talk through how you think about that.
Pat Collins (31:49)
I’ve said this to lots of people over the years is that I’ve never, and I’ll kind of live by this one. I’ve never met somebody that’s gone broke by paying off their debt. ⁓ I have met people that have basically lost all their money by trying to invest in crazy things and whatnot. So it is the most typically the most conservative ⁓ route you can go is to pay off debt. It’s a guaranteed return.
I think you could expand it a little bit. We talked a little bit about this before, which is should I pay off debt or should I invest the money? so mortgages, typically for most people, the largest chunk of that. But it can be other things. It can be credit card. It can be car loans. It can be student debt. ⁓ And I do think that, you know, there is a financial calculation that we can talk about, which is how do you think about, you know, this the option of paying off debt versus investing?
But then there’s this whole other kind of psychological element to it, which is how does it ⁓ just make you feel? How does it actually maybe help you to invest in the future if you don’t have any debt? Some people are even more willing to stick with strategies if they know they’re completely debt free. It’s like, okay, I can live with the ups and downs because I don’t have any other obligations basically. So if it goes down, yeah, I don’t like it, but I can live with it versus.
I have all this, I’m swimming in debt and then I invest in the stock market and it goes down 50 % and I am really stressed because I have like two things that are happening now at the same time that stress me out. So maybe we start just at the, at just the very simple financial formula. And that’s basically, if I have a dollar or two and know, excess dollar, where does it make more sense to, to, you know, kind of allocate that dollar?
The biggest thing is really just looking at the cost of the debt versus their return on the investment that you have. And you want to pick the one that yields the better outcome, essentially. So if I have very low interest rate debt and I’m paying 3 % on that debt and I think I can earn more than 3 % on it in an investment, then it probably makes sense financially, at least, to just keep that money, keep the debt and continue to pay out and invest those funds.
There’s a little bit more to it than that. First that I would say is factor in any tax benefits you get from having the debt. So if you are itemizing deductions on your tax return, you have mortgage debt, then you should be able to basically lower, it’s effectively lowering the interest rate on that because you’re getting a benefit from having that debt. So instead of 3%, it might be more like 2 % that you have to earn. Then on the investment side,
A lot of times people hear maybe, let’s just say the break even is 5%. And a lot of people will look at that and say, ⁓ well, the stock markets average 5 % or average more than 5%. It’s averaged 10 % over the years. In fact, I just heard the other day that the S &Ps averaged 17 % over the last 17 years. So you may look at that in your mind and say, therefore, I should never be paying down this debt. I should always invest the funds.
It’s not an apples to apples comparison when you do that. You were basically saying this is a, the one hand, paying off debt is a guaranteed return I’m getting. I guarantee I no longer have to pay this interest. On the other hand, I’m investing in a risky asset in stocks, let’s say, that could be anywhere all over the board. So I think to really do a true comparison would be to say, what is my kind of risk free rate, if you will, or what can I invest similarly from a risk perspective as to paying off a mortgage?
And then obviously you have to think about your own kind of risk tolerance or whatnot through that, but lots of considerations. But that’s where I would start is do the calculation to say, what is that breakeven rate where it makes more sense to invest than to pay off debt. And that’s kind of step one.
Marcus Schafer (35:54)
It’s interesting if you look at how financial theory progresses, we expect stocks to do better than bonds. Mortgage rates are based upon bond prices. So even if your interest rate is 10%, your expectation is still stocks are going to do better. But there’s definitely more swing from that. So one interesting aspect of this conversation is we have optionality on setting
our mortgage rates, which means if you have a fixed rate and it’s at 3 % and current rates are higher than that, that can make things much more of a clear cut situation. So if interest rates today are at 4 % and your interest rates 3%, man, are absolutely, you’re lucky. You timed the market perfectly. ⁓ Figuring out how to read
refinance or mortgage might be the best market timing you could do. So I think there’s that. ⁓ In addition to think about what’s your true mix that you would reinvest in, what’s the likelihood you would receive it? The other thing is you mentioned there is a tax benefit from interest deductibility. So thinking about that, if you can consider what else might you invest in?
One of the things that the research shows seems to be an opportunity is people are prepaying their mortgage, but they still have room to invest inside their 401k. So they’re paying down a tax benefit, but they’re missing a tax benefit over here. So this is kind of double tax rate arbitrage. And what the researchers did is they looked at it about 38 %
of people who are prepaying their mortgage still have room in their 401k to contribute. if they, instead of prepaying the mortgage, if they invested, they both get the tax benefit here and the tax benefit here. For every dollar they do that, they get about 17 cents immediately of value more than just prepaying.
And then they looked at why do people not do it? And it was exactly what you were talking about before. It was more of a behavioral thing. And, you know, I think that’s one of the values, hopefully advisors should be bringing to the conversation is let’s just balance out behavior with the math, right? And I’m not saying the math is going to win every single time and it shouldn’t win, but that should be part of the conversation. And Hey, if you see the math benefits so much clearer.
and you’re willing to compromise a little bit on some of the behavioral benefits, that’s okay. But you can also make an informed judgment the other way and say, hey, you know what? I’m gonna sleep so much better at night. And by the way, that’s my whole goal with money is to sleep better at night. It’s not to have a number more into the future that I don’t really understand what I’m gonna do with.
The Theory Only Works If You Actually Do It
Pat Collins (38:59)
With so many things, there’s the theory and the practical, and it’s just a great example that you could say that, you know, don’t pay down your mortgage, reinvest that excess that you have and put it into your 401k. But if you don’t actually do it, if you just basically pay your mortgage, ⁓ or maybe it’s, hey, I’m going to put the excess every year into an account.
Maybe it’s not even a 401k, a brokerage account, something like that to reinvest. I’m gonna make a Roth IRA contribution. So many times when you remove the discipline of kind of making it automatic, it doesn’t happen. the whole kind of, there’s the whole concept in insurance where, and we’re probably very big believers in this, that very few people should be buying permanent life insurance. It’s almost like a quasi savings vehicle. They should buy term and invest the difference.
And so so many people will look at that and go, yeah, I agree. And then they will buy term because they do want to have life insurance coverage, but they never invest the difference because it’s just like, I just, you know, I never got around to it. spent it. in all cases, when you’re thinking through a lot of these things of optimizing and whatnot, a lot of times it’s, well, don’t do this, do that. It’s more optimal to do it this way. The only thing I would say to that is if wherever possible, make it automatic.
because if it requires you to take action somehow, most people will just live their lives, they’ll forget about it, they’ll do it in a way that maybe is not as optimal, maybe they’ll forget about it and, yeah, I spent that money on something else, I could only invest half of it, and all the benefits go away. And I see the same thing, sometimes I’ve even said this to clients that have a hard time saving, is even though a pre-tax contribution to a 401k would be better.
Let’s just say they have $30,000 to invest. If they put that 30,000 into pre-tax, they get a tax deduction for $30,000. And therefore, they can even save a little bit more. Actually, a lot of the calculations rely on that. Or I could get no tax deduction and put the 30,000 into a Roth.
Even though it’s optimal, maybe for someone in a high income to do pre-tax, if they’re not going to do the next step of ⁓ taking that excess savings that they got and investing it, it might be better for them to just do the Roth because it’s so automatic and they don’t have to think about it. And then when they do retire, if they have a million dollars in that account, if it was pre-tax, it’s not going to be a million dollars. When they take it out, they’re only going to get maybe 70 cents back on the dollar. Whereas if it was Roth, they’re getting 100 cents back. So again,
Just as you’re thinking about these things, try to make it automatic as much as possible, set up recurring monthly things. That’s why 401Ks work so well, is that you just stop thinking about it. It comes out of your paycheck. It just happens automatically.
Marcus Schafer (42:00)
Yeah, that’s why 401k’s work so well now. And only because we implemented a lot of the behavioral finance research, a lot of the studies you see, this was like the first place where they were implementing it, qualified ⁓ investment vehicles, the ability to force participants to start at a certain rate, to increase that rate over time, to start kind of thinking, hey, people are going to get raises. Let’s automatically increase the 401k.
these are all features that are working and actually make the 401k vehicle ⁓ as quote successful as it is now compared to what it was before, because before these ⁓ innovations of kind of for savings behavior existed, we actually didn’t see a lot of ⁓ a lot of the same success in the 401k space. ⁓ we talked
saving for retirement kind of common vehicles. talked mortgage. ⁓ Any other key goals that you think deserve a conversation in that?
College Savings, 529s, and Optionality
Pat Collins (43:10)
I think one of the other ones that comes up quite a bit is, especially for young families, is college. And again, we all have limited resources. So we have that extra dollar. How much of that should we be putting towards college versus retirement versus maybe at some other shorter intermediate term goal?
I have some feelings about this. think it does really come back to the values and the goals of every single family. But in general, my take in just seeing clients over the years is that there’s lots and lots of ways to send your kid to college. And you can get creative. It could be scholarships. It can be community college for a couple of years. It can be a state university instead of a private university. So there’s a lot of different ways to control.
the costs of college. And quite honestly, could even be some portion of it could be debt that your kids take out to kind of have some skin in the game. There’s very few ⁓ or maybe none ⁓ ways that people are going to support your own personal retirement or your own personal way to buy that next house ⁓ or whatnot. So if I were looking at it, I would say.
that next dollar, even though maybe the next goal that I have is education, college goals for my kids, I would be careful about trying to fully fund that. And at the expense of all of these other personal goals that I have for myself, and I know that may sound a little bit harsh to the to the next generation, and I’m not saying everybody should do this. Obviously, it does depend on your circumstances, you know, what your wealth level is. But if if you can’t do all of it.
If you can’t send your kid to college and retire at a reasonable age, and those are both important things to you, I would be careful about over-prioritizing college and not saving for your own personal retirement. I don’t know about you, but I think, you know, if I think about my own family, I think my kids would probably rather have to pay off a little bit more debt.
than me being destitute at 75 years old and then feeling like a major obligation to take care of me. So I do think that these are all really tough questions, but I would just be careful to just automatically go to, well, I’m have to pay for college before I get to retirement. And so again, this is where a financial plan comes into place and to think through this and how much could you pay of both and whatnot.
But again, all comes down to trade-offs. I would just be careful because there are other ways to pay for college. It may not be optimal for your child. They may not wanna do it that way, but it might be the most optimal thing for you.
Marcus Schafer (46:04)
It’s just this challenge, right? Where you’re kind of saying, hey, I’m weighing two separate goals. And in my situation, those goals are 15 to 20, 25 years into the future. ⁓ And this is where the saying optionality has value. And if you restrict that optionality, there’s a cost to that. And this is where I do think that there’s ⁓ one benefit, which is
The closer you get to something, you have more certainty, right? If my kids were in private school, I should be funneling tuition payments through a 529. And that doesn’t require any future foresight into what’s happening in the future. That can be more immediate, right? So there’s certain things you might be just missing ⁓ in the moment. You might be able to claim a state tax deduction here, and that might make it a little bit easier. But it’s balancing that. The question I have for you is,
does the recent change ⁓ that enables 529s to be converted to Roth accounts? ⁓ Does that change your calculus at all? I think it’s an intro.
Pat Collins (47:14)
Yeah, I think a little bit. I mean, most of that is going to be going to the beneficiary of the 529 plan. So it’s going to be the kids that really get the benefit of that Roth, you know, later on. And so, again, it comes back to do I have enough wealth and assets and savings to be able to be able to do that? ⁓ So it helps. It does give you some optionality. We also have people that are, you know, have access in their 529 plans and they’re saving it for their.
They’re even converting it to others. They’re to say their grandkids is just another option. So there are some things that you can do there. But the one other thing that I would say around this optionality piece, and this is another thing we talk to clients about is sometimes preserving that optionality is really important because we don’t know the future and it might be better and you might pay a little bit more tax to have some of your college savings for your kids in a brokerage account.
And because you don’t know what the future is going to bring, you don’t know if they’re going to go to a public or a private school. You don’t know if they’re going to go to a trade school maybe or, you know, Canadian college or the local university and live at home for, you know, for a few of those years. So there’s so many potential outcomes that if you’re kind of saving for the worst case scenario, you may end up with, and you’re doing it in a 529 plan that has a lot of restrictions to it. You may end up with a lot of money in a 529 plan that you don’t need.
And so while that might be optimal from a tax perspective, it’s not optimal because now all of a sudden I had to get the money out of it. And now I’m to have to basically leave it in there for my kids, for my grandkids, convert it to a Roth for my kids maybe. I mean, there’s a lot of different things that I could do, but it doesn’t really help me with my own personal retirement necessarily. So we’ve counseled a lot of people to maybe save half to two thirds of their anticipated college in a 529 plan and the rest.
plan on maybe using some of your income to pay for it ⁓ or using a brokerage account to pay for it. Because if you don’t need it, then now you have access to this pool of capital that has no restrictions on it. again, giving yourself some optionality at the expense of optimization may not be a bad thing.
Marcus Schafer (49:27)
I think that makes a lot of sense. also, I think maybe there’s this question, maybe it’s said, maybe it’s unsaid, but I’d be interested to get your take. And that’s around, you if you take the 529 to Roth ability, or you just take Roth accounts in general, what’s the confidence that the government’s not going to change its mind and double tax us on that down the road? ⁓ How do you just think about
that when it comes to Roth, like you’re paying a big upfront tax bill and now it’s a agreement that we’re not going to get double taxed.
Pat Collins (50:08)
I think there is some risk. mean, I think it’d be foolish to say there’s no risk. I think the ⁓ prevalence of Roth, especially with the wealthy class, it seems like the people in Roth should be the folks at the lower end of the income scale because they’re the ones that are ⁓ getting some, the main benefits of paying very little income tax. But there’s a couple of things. One is I think the prevalence has grown so much that it would be
politically really tough to push something, some legislation like that through without not getting reelected basically, which as we all know is probably one of the main motivations of most politicians out there is to get reelected. So I think that’s a tough one. The other thing is it is a, ⁓ the Roth accounts themselves are massive revenue raisers for the government.
You know, when they put these in place, now what people are doing is they’re saying, I’m not going to get a tax benefit now by investing in a 401k. I’m going to pre-tax. I’m going to pay tax now and get, you know, get this benefit later on down the road. So I think if they were to eliminate that or curtail it somehow, I think it would cause all sorts of people to not
Contribute to Roth which just blows a hole in the budget forecast that they have so I think it’s going to be very very difficult for them to unwind something like this I don’t want to say it’s impossible or they try to mean stances somehow where it gets a very high folks high income folks are the ones who get Pushed out, but I think it’s very very unlikely just because of the political and and and budget repercussions at the government level. Yeah
Marcus Schafer (51:49)
Yeah,
I mean, I think mostly about the budget repercussions. mean, the government, you know, they’re say what you want about them, but they’re they’re going to try and get their they’re going to try and get their money. And if people are willing to pay more money now, they’re going to get that. then you see kind of the opposite of this and what’s happened with RMDs for those that don’t know. If you’re in a traditional 401k or traditional IRA,
which means you haven’t paid money on the funds in there and you’re going to pay when you take them out. The government kind of says, hey, as you start getting up in age, we’re going to force you to take that money out because we need to raise our tax revenue. This isn’t going to go on forever. Forever. There’s kind of implications for people that might inherit those assets. What happens forcing them to distribute the money? The government’s going to get its money. so Roth is one of those ways that the government’s going to get its money now.
Build a Repeatable System
Pat Collins (52:48)
So, so kind of maybe wrapping up, ⁓ you know, we talked a lot about different ⁓ competing interests, but I for your next dollar of savings. But I’ll go back to one thing, just maybe one last thing to kind of wrap up from my end is just a reiteration, which is think about this waterfall effects. There are priorities that we think you should take over others that are very immediate term. If you are living with no savings, cash savings, that needs to be addressed.
If you’re living with high interest debt, 15, 17, 20 % interest debt, get that paid off. If you are not taking advantage of your 401k match or any other matches that you have, at least get to the level where you get that money, that free money. And then we kind of get into that second level. So I think it’s really trying to figure out what’s the order of operations with that. Make sure you’re taking advantage of those top things first before you move on to some of these.
More things at the margin, I would say, really matter, which is paying off debt versus savings, pre-tax versus Roth IRA or 401k, ⁓ college versus taxable brokerage account, things like that. All important, but if you don’t get the first things right, these things aren’t going to be as important.
Marcus Schafer (54:07)
Yeah, I think that’s all well said. It’s what struck me is some of that research around people preferring illiquidity. And it goes back to one of those personal finance terms, pay yourself first, which means, hey, can you actually build in some frictions yourself in your paycheck? Can you automatically route money into a taxable brokerage account? Can you set up a dividend reinvestment plan or make sure an advisor knows every time that the cash hits the account?
go press the buy button. ⁓ That kind of using frictions to your advantage, that’s a tool that you should try to build in and build in once so you don’t have to keep revisiting this because sometimes the indecision is worse than any decision.
Pat Collins (54:54)
Absolutely agree. Well, with that great episode, great talking to you. Happy investing to everybody here.
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