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On today's AMA episode, we have a question about how to properly measure opportunity costs. Another question
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about whether retirees should consider investing in TIPS, which are inflation protected bonds. And then last, a
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question about how to properly assemble a cohesive portfolio from your various different investment accounts. Stay
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tuned. >> Welcome to Personal Finance for Long-Term Investors, where we believe
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Benjamin Franklin's advice that an investment in knowledge pays the best interest both in finances and in your
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life. Every episode teaches you personal finance and long-term investing in simple terms. Now, here's your host,
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Jesse Kramer. Welcome to Personal Finance for Long-Term Investors, episode 142. I'm Jesse Kramer. I'm a financial
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planner working with retirees and people planning for retirement across the USA.
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You can learn more at planwithjesse.com. This week's review of the week is from
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Colorado Boy MJ who left a five-star rating and review on Apple Podcasts. So, Colorado Boy, send me an email to
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jessebinterest.blog blog and I'll get you a super soft podcast t-shirt mailed
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out your way. Thank you for the five-star review. And with that, let's just dive into the AMA questions. The
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first one comes from Stephanie who wrote in and said, "Jesse, I see some confusing things online when it comes to
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opportunity cost. The first has to do with spending money on fun things, for example, a $5,000 vacation. People will
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say, "But if you invested that money instead at 10% per year, you could have
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had $225,000 in 40 years." And yes, I think that math is correct. So that's
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Stephanie's first question. And then she says, "Also, the opportunity cost of
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working with an adviser." Yes, Rammit Seti talks about how a 1% annual fee will cost you 40% of your wealth over
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your lifetime. Do you agree, Jesse, with how these examples are illustrated? Stephanie, I love this question. And in
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short, do I agree? The answer is yeah, yes and no. Uh, I do agree somewhat, but then I think there's some important
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nuance we have to add. And I think the best and most way to fund start this answer is with a personal example. So,
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okay, if my family changes nothing about our current financial situation and we continue saving and investing the slow
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and steady manner that we currently are, I bet we'll have around $5 million by
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the time we reach retirement age as measured in today's dollars. The slow and steady trajectory of compound
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interest over 40 years. And that's our base case, $5 million. Let's just use
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that. Last year, 2025, looking at food, the category of food, groceries and restaurants in our household budget, we
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spent about $15,000 on food last year as a household. But I would say that if we
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truly went as cheap as possible, we're talking rice and beans and oats and peanut butter, some pasta, I bet you we
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could cut down our food expenditure to about $3,000 a year. So from 15,000 a year down to 3,000 a year. Or you could
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say about $12,000 a year in annual savings. Now, if we took that $12,000 a year in annual savings, we invested it
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all the way that we currently are, I think you could easily make an argument that our food habits are costing us
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something like $3 million by the time we retire or something like 25% of our retirement nest egg. But that brings up
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three very important questions. Now, the first is does it really make sense to scrutinize our expenses this way? And
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the second is kind of mathematically and logically, does it make sense to inflate
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those costs? in this case the cost of food does it make sense to inflate that cost into our future at our rate of
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investment at 10% per year does that make sense mathematically and logically and then the third question I have is
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are these pure costs in other words is there no benefit that we get from this expenditure is there nothing on the
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other side of the balance that we need to think about so I think those are some really important questions so we'll
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tackle the first question does it make sense to scrutinize all of our expenses this way there's a gentleman by the name
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of Derek Tharp he's a PhD HD researcher. He works for Michael Kitsus, kitsis.com,
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probably the most acclaimed website for financial planning education. And he took a look at this one in one of his
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articles. And some of the interesting examples that he came up for this hypothetical retiree he calls Sarah. He
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found that about 7% of Sarah's retirement nest egg was eaten up by the family trip that she went on to Disney
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World when she was 5 years old. Again, if you take the expense of that trip from when she was like five years old
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and if you were to inflate it at an investment rate until she retires, 7% of her retirement nest egg went to that
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Disney trip. About 20% of her retirement nest egg was eaten up by going to college. 27%
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uh due to her long career-long daily coffee latte habit. 27% went to her latte habit. About 37% of her retirement
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nest nest egg was consumed by her parents feeding her from age 0 to 18. About 45% was eaten up by her buying a
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Honda Civic once every 10 years beginning at age 16. The point is that if you're going to analyze life this
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way, you're soon going to realize that all the mundane ways that you're spending money, if you want to inflate
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them at something like 9 or 10% per year for decades, you're going to end up with
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really big numbers. That's just the way that compound interest works. And this
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is striking, a striking fact, but we know it. And compound interest, the whole point of it is that each extra
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decade matters more than the decade before it. So if we do this type of math for 60 years, like that Disney trip in
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this example that Sarah went on when she was 5 years old, it ends up being much more consequential than money she might
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have spent when she was 40. But I hope you agree with me here that this choice of analysis, I should say, is a slippery
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slope. It might start with asking yourself about that $10,000 vacation, which honestly it's just a vacation.
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It's it's all extra. And you could invest that for another 25 years. And
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maybe that would equate to half a year's spending, right? And that so that the
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$10,000 vacation, it's half a year of spending. It really means that you could
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retire 6 months earlier if you didn't go on that vacation. Okay, you could start
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the analysis there. But then, are you going to analyze your groceries in the same way? Are you going to analyze the
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gas you put in your car the same way? the clothes you put on your back, you know, the registration for your kid's
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te-ball league. There's a funny motif in the personal finance space about differentiating between frugal and
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cheap. The two adjectives obviously are similar, but frugal tends to have this good connotation, while cheap has a bad
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connotation. And let me tell you, if you're skimping on gas and food and your
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kids T-ball registration in order to retire 12 days sooner, I'm pretty sure you've jumped the shark into cheap
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territory. And it's not even close. It's one thing when you want to analyze all
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the extracurricular stuff in your life and you want to ask yourself, hm, what could this cost me if I chose to inflate
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it at an investment rate for the next few decades? It's totally different if
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you take all the legitimate important ways that you spend money like food, like gas in your car, and you start to
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think about life that way. I just think it's a slippery slope till you get to
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some really gigantic numbers that are going to convince you to live life like a cheapkate, and I don't think that's
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really worthwhile. Let's go to the second question. And the second question was, mathematically and logically, does
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it make sense even to inflate these costs into our future at our investment rate? So, if we go back to the $10,000
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vacation example, imagine someone who had the choice of going on that vacation or putting those $10,000 to work into
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the two spouses Roth IAS. Now, in that case, I don't see a problem using an investment like rate of return on that
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money. I get it. It's kind of this clear choice between vacation, Roth IAS, easy.
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And if it's going into the Roth IAS and you're going to invest it for retirement, you know how you ought to be
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discounting that money back to today. But I'm going to counter my own argument
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with this. There are important reasons why Warren Buffett uses the risk-free treasury rate when he's doing his
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version of opportunity cost analysis. Now, in that case, Buffett is analyzing maybe whether to buy a business or not.
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And in order to properly baseline himself, he uses the risk-free rate provided by US Treasuries, which as of
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this recording is somewhere between 3 and a half and 4%. So after adjusting for inflation, probably more like 1 to
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1.5%. Now that discount rate, and that's what it's called, a discount rate. It's
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a massive part of the analysis here. It's huge. If you've invested, say over
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the recent 10 years, you've watched your S&P 500 fund grow at 14% a year or
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whatever, and you use that as your discount rate. Well, if I used 14% as my discount rate, then my family grocery
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bill that I discussed earlier a few minutes ago, that would cost me $20 million by the time I retire. That's
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actual math. $20 million by the time I retire. But if I instead use the inflationadjusted treasury rate of 1.5%
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like Warren Buffett would, then the groceries would only cost us about $600,000. And almost all of that
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$600,000 would simply be the $12,000 a year in costs of the groceries. 40 years times $12,000 a year gets me to
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$480,000. In other words, almost none of it is wasted investment growth if you use a
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discount rate of 1.5%. The cost of spending money on groceries is basically just the cash out of my pocket itself.
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But if I inflate that grocery cost at 14% a year, that's where I get to $20 million of wouldbe retirement dollars
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that I'm foregoing. So, by inflating these costs at a portfolio investment rate, we're assuming future returns.
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We're assuming future behavior that we're going to keep it invested. We assume that we invest 100% of those
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dollars instead of spending them on something else, right? So, instead of spending the money on groceries, maybe I
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could go spend the money on a vacation or on a new car. No, no, no. I'm assuing
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every single expense I possibly can and just dumping it all in my portfolio. Now, to each their own, but that really
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doesn't conform with with reality as I experience it, as I see it. And this was
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kind of funny, the timing here. Another idea, the very famous fire blogger, Mr. Money Mustache, recently published a
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post called The Shockingly Simple Math of Social Security. And then I published a rebuttal right after called When the
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Shockingly Simple Math is Shockingly Wrong. And I'll link both articles in the show notes. But to make a long story
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short, Mr. Mr. Money Mustache concluded that collecting social security at age 62 is the optimal solution because if
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you invest that money in index funds and if you achieve a 6% inflationadjusted return, we'll call it like a 9% nominal
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return, right? 6% inflation adjusted. He claims it'd be better than the return
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you would get by delaying social security maybe to age 67 or 70. And mathematically that's true. If you
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compare the way that social security increases work between ages 62 and 70 and then if you compare that to a 9%
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rate of return, yeah, the 9% rate of return is better. But Mr. Money Mustache is repeating a very common and pretty
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major folly because when we choose a discount rate, when we choose that again that opportunity cost rate, it's
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important that we match the risk of the cash flows. Now in simple terms that means that our discount rate has to
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reflect the risk that in this case is built into social security. A common phrase in discount rate discussions is
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your next best option of similar risk. So does the risk of the stock market reflect the risk of social security?
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Certainly not. The social security annual increases that you'd earn by delaying your benefits are guaranteed by
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the full faith and credit of the US government. That's about as risk-free as
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it gets. Now, stock index funds, which candidly I own a ton of, I'm a big stock
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index fund guy, but stock index funds do not come close to meeting that high bar
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of being risk-free. I mean, after all, if we're going to use a a 9% discount
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rate to reflect index fund investing, why not use a 20% discount rate that reflects Berkshire Hathaway's annualized
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return for the last 70 years? Why not use a 230% discount rate that reflects Bitcoin's annual return since inception?
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And I think the reason why is because those comparisons clearly are not apples to apples with social security. We just
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recognize that on its face. Using Berkshire Hathaway or Bitcoin like returns to compare to social security
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just does not make sense. We all know it. Well, using a stock index fund return might be less egregious, but it
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suffers the same exact flaw. So, how do we correct this error? What discount rate makes sense? I think we have to go
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back to that idea of the risk of the cash flows or our next best option of similar risk. Social security behaves
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like a government guaranteed annuity with some inflation protection built in. So the next best option of similar risk
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would probably be something like TIPS, Treasury inflation protected securities. And the current TIPS yield ranges from
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about 1% to 2.5%. So that's a real inflation adjusted return between 1 and 2 and a.5%. So if we want to pick a
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number in there, let's say 2% is right in that range where Mr. Money Mustache
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is using 6% as his inflation adjusted discount rate, I would say that the right answer is 2%. And if you plug that
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in to the same equations that he used and you say that you want to live to age 90, well then clearly delaying social
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security to age 70 becomes optimal if you discount your future cash flows at 2%. And so I would argue that the
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shockingly simple math of social security is actually shockingly wrong. Anyway, that was a little bit of a
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digression about social security. I also think for what it's worth, social security is certainly more nuanced than
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uh just thinking about yourself and your own situation, right? You have to think
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about your spouse. You have to think about ideas like it's longevity insurance after all. Anyway, there's
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more than meets the eye. I wouldn't say that much about social security math is
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even simple, let alone shockingly simple. But going back to Stephanie's major question about opportunity costs,
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the third subquest that I outlined to you about 10 minutes ago is that are these things pure costs, right? Is there
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nothing involved on the other side of the balance? Meaning, when my family spends an extra $1,000 a month on food
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instead of just rice and beans, is there nothing we get in return? Could we measure our return in health outcomes?
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Could we measure it in the pleasure of eating good food and diverse flavors? measured in the joy of not eating peanut
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butter oatmeal for breakfast for the rest of my life. My point is there, we're buying something. We're buying
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something beneficial with this money. When your family takes a trip to Disney World, is there nothing you get in
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return for that? No memories, no smiles, no relaxation. And getting back to the the other part of the question that
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Stephanie asked, if you choose to spend 1% a year on your financial adviser or $400 an hour or $10,000 a year as a flat
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fee, you pay an accountant, you pay an attorney, you pay any professional. Is there nothing that you get in return for
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that? And I think that's where Rammit Seti and many others who use this math
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get it pretty wrong. Their analysis always shows two investors with the same exact financial life in every single way
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except that one of them is paying a fee and the other one is not. Now, of course, if you present it that way, the
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side of the analysis with extra costs is going to come up worse. And that really
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assumes one of two things. it it assumes that the adviser is adding zero value or
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it's that the DIYer the person who's not paying an adviser has the financial
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planning knowledge and the experience and the behavioral fortitude etc etc to match the outcome of hiring a financial
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planner now I do think some advisers add not much value and I do think some DIYers are phenomenally knowledgeable I
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interact with folks like you all the time but I think and many smart studies think that advisor alpha that's a term
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they use that advisor alpha is a real thing. It's the added value that working
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with an adviser brings. You know that adviserss can and many do add value to their clients lives in excess of the
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fees that they are paid and you can measure it in dollars and cents. So again, if you pay your plumber $2,000 to
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fix a clog in your front yard sewage pipes, is that a pure cost or are you preventing some problem from getting
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much worse, compounding against you, and then costing you way more in the long run? If you run a business and you pay
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an accountant five grand a year for a consultation that saves you 10% on your tax bill every year going forward, was
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that a pure cost or will it pay for itself in some really big way over the coming decades? And I think this example
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that Stephanie Rammit Seti bring to this episode is is kind of similar. If you view an advisory relationship as a cost
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with zero benefit, well, of course you shouldn't pursue it. That's just common
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sense. In fact, we probably shouldn't even be talking about the costs then. we
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should instead focus on the fact there's a bigger elephant in the room which is
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why would these people exist in the first place if they're adding zero benefit to anyone's lives. I think the
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uh assumption of a pure cost and zero added value is probably a logical fallacy onto itself. So I don't agree
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with the illustration that Ramit Seti paints. At the same time does he raise a good point about 1% fees? Sure he does.
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He's copying John Bogle by the way who raised the same argument for decades before anyone else. Good for John Bogle.
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So then the question is does John Bogle have a good point? I think yeah he does.
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The more time I spend in this industry the more I realize that some of my work doesn't seem to scale with assets at
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all. It just it just doesn't. At the same time some of my work does scale with a client's assets. And similarly
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let's think about the responsibility I owe to my clients or owe to you the listeners. The risk of screwing up
00:16:56
someone's scenario. Does that responsibility scale with assets? Yeah, in some cases absolutely. Does my risk
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exposure to my own errors scale with assets? Yep, it does. In other words, some portion of my work does seem to
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grow as people's portfolios grow. So, you know, if I had a blank slate, I think that's the fee model that probably
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is the most logical for the work that I'm doing. You know, I recognize that some of my work doesn't seem to scale
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and everyone who shares in that work or everyone who gets the benefit of that work ought to share some sort of similar
00:17:27
flat fee. Anyway, that's just my two cents on it. Thank you, Stephanie, for the great question. Here's a quick ad
00:17:34
and then we'll get back to the show. I send a free weekly email to thousands of
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retirement. And you can sign up for free at bestinterest.blog. Next, James writes in. James says, "An
00:18:25
AMA topic I would love to hear your thoughts on is Jason Zwag's enthusiasm for tips. He wrote another Wall Street
00:18:31
Journal article over the past few days. He's almost got me convinced to really
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look into these to set a floor for the first 10 years of my retirement. Awesome question, James. Jason Swag is a
00:18:41
terrific writer who writes mostly for the Wall Street Journal, although I think he does have his own website.
00:18:46
Maybe he just republishes his journal articles there. But anyway, Jason Swag. Highly recommend Jason Swag. Let's get
00:18:51
into the question. What are TIPS? TIPS, TIPS, stands for Treasury Inflation Protected Securities. It's a type of US
00:18:58
government bond, kind of like a simple Treasury bond, but as the name implies, tips are set up to protect you against
00:19:03
inflation. With a typical bond, your principal is fixed. You buy $1,000 of a bond. And the promise is that you're
00:19:10
going to get your $1,000 back at the end of the term plus a particular interest rate along the way. But with TIPS, the
00:19:16
principal itself, the $1,000 part that I just mentioned, the principal itself can
00:19:19
go up or down over its term. When the TIPS matures, when the individual asset matures, if the principal is higher than
00:19:26
the original amount, you get that increased amount. But if the principal is equal or lower to the original
00:19:31
amount, you don't get less than what you started with. They actually kind of bump
00:19:35
you up to your original $1,000. We'll get into what forces can move that principal amount up or down. But TIPS,
00:19:42
like all bonds, they also pay you an interest rate along the way. The interest rate is fixed for TIPS. It pays
00:19:48
out every 6 months. And because the underlying principle is rising or falling with inflation, that means that
00:19:55
your interest payments actually rise or fall in sync. So current TIPS rates as I
00:20:00
write this are paying about8% on the short end. So that's like a one-year TIPS and about 2.5% on the long
00:20:07
end. So that'd be like a 30 years TIPS. Now those rates 8% on the short end,
00:20:11
2.5% on the long end. Those are noticeably lower than regular Treasury note treasury bill Treasury bond rates
00:20:19
right now which are about 3.7% on the one years and 4.9% on the 30 years. And the difference between the TIPS rates
00:20:27
and the Treasury rates again if you measure it's about 2 and 1 half to 3% is
00:20:30
the difference between those two rates. That's the implied rate of inflation
00:20:34
that the bond market is expecting. Okay. So what does that mean? Well it means if
00:20:37
you take the one-year TIPS which are paying8%. and you compare that to the one-year
00:20:42
Treasury, which are paying 3.7%. The difference between those two payouts, it's about 2.9%.
00:20:48
And if inflation ends up being 2.9% over the next year, then the TIP's total
00:20:54
return will be inflation 2.9 plus8. And that's going to be the equivalent of the
00:21:00
one-year Treasury. If inflation ends up being higher than 2.9%, then the TIPS return is actually going to beat the
00:21:05
one-year Treasury return. and vice versa. The bond market itself, the investors, the buyers and sellers in the
00:21:11
bond market, they know that's that's how this interaction works. And at least for
00:21:15
today, they've pretty efficiently agreed on these interest rates. Thus, the bond
00:21:20
market's implied rate of inflation over the next year is about 2.9%. Now, TIPS and Ibonds, very similar
00:21:28
products, but they are slightly different. Ibonds are treasury bonds that pay a fixed rate of interest as
00:21:34
well as an additional layer of interest that varies with the current inflation rate. So it's interest plus interest
00:21:40
instead of adjusting the principal value like TIPS do. Ibonds are available only
00:21:45
to individuals. They're available with face values as low as $25 from the US
00:21:49
Treasury. Ibonds reach their final maturity in 30 years, but investors can begin cashing them in just 12 months
00:21:55
after purchase. And I believe if you redeem them within three years, maybe within 5 years of buying them, you end
00:22:02
up forfeiting some of your interest. Point is, Ibonds are really similar. There's also an inflation protection
00:22:07
aspect, but they're slightly different. So, what's good about TIPS or Ibonds for
00:22:12
that matter? Like, why are we even addressing this question in the first place? The main reason why is because
00:22:16
they are one of, if not the best asset at specifically addressing inflation risk. This one risk, inflation risk.
00:22:23
That's what they're designed to address. you are guaranteed a positive real
00:22:27
return. Right? In the case of a one-year tips that we mentioned a minute ago, with a 8% interest rate, you are
00:22:32
guaranteed to get your money back plus inflation plus another8%. That is certainly an interesting value
00:22:39
proposition for investors, especially someone who's looking to match some sort
00:22:44
of specific asset today against a specific liability in their future financial plan. But what are the
00:22:50
downsides of TIPS? Well, for starters, because TIPS are inflation linked, their fixed interest rate is just similar
00:22:56
lower. It's just much lower than that of a standard Treasury bond. We already
00:22:59
discussed this. It's that risk return trade-off. Investors demand less nominal
00:23:05
yield for accepting inflation risk. But then there's another little added wrinkle. Because of the fact that we're
00:23:11
sherking inflation risk altogether, we expect the total return of TIPS to actually be lower than the total return
00:23:18
of treasuries over the long run. Maybe not every year as there will be years where inflation surprises us by being
00:23:24
higher than expected and in those years tips will outperform plain treasuries. But over the long run because tips are
00:23:30
just totally ignoring inflation risk or or what I should say is that they've
00:23:34
been designed to absorb all the inflation risk. They just have less risk and it probably means they're going to
00:23:39
underperform a similar term treasury over the long run. Now, second, just because tips are linked to inflation,
00:23:45
which they are, it doesn't mean that they're immune to interest rate shocks,
00:23:49
right? Inflation and interest rates, two different things. And even though these
00:23:52
two different things are often talked about at the same time, like 2022, right? Inflation was high postco and
00:23:58
what did we do? We raised interest rates. So, they're often talked about at the same time, interest rates being a
00:24:03
tool to fight inflation, but they're two different things. And in 2022, when
00:24:07
inflation got up around 9% at one point, I'm sure many of you must be thinking,
00:24:11
well, TIPS must have done great that year. The principal value went up way more than we were expecting because
00:24:16
inflation was high. And people still got their interest and that must be a really
00:24:19
good thing. But you know what else went up in 2022? Interest rates went up and tips are not immune to interest rate
00:24:26
risk. And you could look at, for example, an index of tips maintained by Bloomberg. It's called the Bloomberg 1
00:24:32
to 10year US government inflation linked bond index. and it measures the performance of US tips with maturities
00:24:39
between 1 and 10 years. And that index dropped about 15% in 2022. And it didn't
00:24:44
drop because inflation was low. Inflation was quite high. It dropped because interest rates went up so much
00:24:50
that the interest rate risk of tips overshadowed any sort of inflation adjustments along the way. And the
00:24:57
longer the tips, meaning, you know, 30 years versus 5 years, the greater the interest rate risk. So anyway, inflation
00:25:03
and interest rate risk, two very different things, and TIPS are not immune to interest rate risk. And then
00:25:09
the last one I'll say is there are some peculiar tax planning idiosyncrasies
00:25:12
with tips. Tips interest is taxed as ordinary income, but the inflation adjustment is not taxed until the bond
00:25:19
is is held to maturity. So anyway, just a little wrinkle. James in his question talks about possibly using tips to set
00:25:25
the floor for the first 10 years of his retirement. And listen, James, I certainly think you could do worse than
00:25:30
this. Not a bad plan at all, especially if you're concerned specifically about
00:25:34
inflation risk. Personally, if inflation risk was that strong in my mind, I still
00:25:38
think I would hedge my bets and build maybe half my ladder with tips and the other half with regular treasuries. That
00:25:44
way, whether inflation surprises to the upside or to the downside, you always know you're going to be about half right
00:25:50
and half wrong. And then there's often another question that pops up, which is,
00:25:53
why don't I just build a 30-year TIPS ladder to cover my entire retirement inflation protection 100% guaranteed for
00:25:59
the next 30 years? I get where the logic comes from, but to me at least, this would be an example of like the ultimate
00:26:05
trade-off between absolute security in exchange for limited spending, limited assets passed down to my heirs in
00:26:13
exchange for having that last check bounce at my death, that type of scenario. I think most people don't want
00:26:18
limited spending. They don't want their last check to bounce. They don't want to
00:26:21
leave nothing to their heirs. Yeah, they do want some security in their retirement plan, especially in the near
00:26:26
term, but they also want there to be some sort of longerterm growth engine for the later half or the later
00:26:31
two-thirds of their retirement. And they want that growth engine for whatever their own reasons. Uh, and anyway, tips
00:26:37
don't really answer that need, and tips present kind of a long-term growth risk
00:26:42
for retirees. So, anyway, James, thank you for the question. I hope that helped you out. Here's a quick ad and then
00:26:48
we'll get back to the show. I love getting your questions and some of you ask me questions about the wealth
00:26:52
management firm I work for in Rochester, New York. Others ask about the Best Interest blog and this podcast, Personal
00:26:57
Finance for Long-Term Investors, which operate without advertising, without pushy sales, and with no pay walls. How
00:27:03
can the blog and podcast stay afloat without me dumping my own money into it? Well, to answer both those questions, I
00:27:08
want to point you to episode 78 of Personal Finance for Long-Term Investors. I intentionally recorded
00:27:13
episode 78 to shine light on those topics and inform you how you are actually helping and can continue
00:27:18
helping these projects carry forward. So if you've ever been curious about the
00:27:22
business of my blog and podcast or if you're curious about my day job in wealth management, please check out
00:27:27
episode 78 and let me know what you think. And then last today we have a question from Dave B. Dave talks about
00:27:33
in his relationship they each have a 401k being rolled into IAS. They have an HSA infidelity. They have IAS and Roth
00:27:39
IAS at Vanguard. They also have a joint taxable account at Vanguard. And his first question is, do you have any ideas
00:27:45
on the best way to portfolioize portfolioize this entire mess? That is, you know,
00:27:52
should we be diversified in each and every account and take certain percentages from them yearbyear? Do we
00:27:57
diversify across all the accounts in each institution? Do we diversify across all the accounts in total? So Dave,
00:28:04
thanks very much for writing in. I really like this question. I actually see two main questions. So let me know
00:28:08
if you agree here. The first or at least easier question to answer is that yeah,
00:28:12
I if you're asking, I think you should consolidate all of your accounts with
00:28:17
one custodian. There's simply not enough good reasons to keep different accounts
00:28:20
at Schwab and Fidelity and Vanguard and all the others. I think just consolidate
00:28:24
as much as you possibly can. The second and certainly harder question. I think the question you're really asking is how
00:28:30
do I allocate inside each of these different accounts such that they are good parts of the whole portfolio?
00:28:36
Should you focus on asset location or tax location to ensure that you're housing your assets kind of as
00:28:42
efficiently as possible? Uh and so anyway, or you know, do you think of just should each account look the same?
00:28:48
You know, just to make it simple. If your total portfolio needs to be 60/40, should every single account be 60/40? I
00:28:54
think that's kind of what you're getting at here. Now, my my short summary view
00:28:58
is that you can think of it like this. Asset allocation is your that's your broad investment philosophy and that's
00:29:04
just a fundamental part of financial planning. Whereas asset allocation, the specific assets that go into specific
00:29:10
accounts, that's part of your tax strategy. It's certainly nice to get right, but it's not quite as fundamental
00:29:17
as asset allocation. So allocation versus location, I know they sound very similar. I'm sorry about that. One is
00:29:23
foundational. The other one is just kind of a nice to have. It's incremental.
00:29:26
I'll kind of pose to you a couple different ways to solve this problem that hey, all really smart people talk
00:29:33
about. So both of these solutions that I'm about to talk about are vouched for
00:29:37
by some pretty smart folks, but they're just different ways to solve the problem. So we're going to start with
00:29:40
the bogleheads, right? Disciples of John Bogle who really value simplicity. And I
00:29:44
would say that the traditional Boglehead way of solving this problem, very simple, very straightforward. They would
00:29:50
say that one, asset allocation dominates results. Two, simplicity is a feature not a bug. Simple is better than
00:29:57
complex. Three, to worry about asset location. It adds complexity without a guaranteed payoff. And that four, having
00:30:06
identical kind of mirrored allocations across all your different accounts. It makes everything very clear from a risk
00:30:13
point of view and ensures your true risk exposure stays consistent across your entire portfolio. So in short, you've
00:30:19
got a bunch of plenty smart investors here who say that the best way to portfolioize your assets is to come up
00:30:25
with the right asset allocation for you, that is, you know, percentage of stocks,
00:30:28
bonds, and cash in total and then do your best to mirror that same allocation across all your different accounts. Is
00:30:35
it simple? Absolutely it is. Does it leave some potential tax optimization on the table? It certainly does. Now, do
00:30:42
each of us need to find a balance between simple enough that we can execute it and stick with it versus
00:30:47
complex enough to capture as much of the juice as we can possibly squeeze? Yeah,
00:30:52
I think that balance is going to look different for every single one of us. But anyway, that's the bogalheads
00:30:56
approach. So, a bunch of smart people, especially those who like to think about taxes and tax planning, would push back
00:31:02
on that simple bogalhead approach and they would say, one, taxes are a legitimate drag on investment returns
00:31:08
and therefore need to be considered. Two, getting asset location correct can materially increase your after tax
00:31:14
wealth. I wrote an article, I'll link it in the show notes, and and really what
00:31:18
it links out to is a deep Vanguard study that showed for the average investor something like.1% to 2% per year in
00:31:26
increased returns due to optimizing their asset location. And depending on how big your accounts are and your
00:31:33
personal tax bracket, that number could be as as low as zero, but it could grow as high as to like 04.5%
00:31:39
per year. So anyway, so the point there is that getting asset location right, it
00:31:44
can add up. It really can matter. And then the third point that I think people would push back on bobbleheads is they
00:31:49
might say, "Hey, you're already managing a a semicomplex retirement plan. Why
00:31:53
should it matter to add one more semicomplex lever?" you're like, you're
00:31:56
already doing it and tax location, asset location isn't any more complex than
00:32:00
some of the other components of your retirement plan. And I think these people would argue that yes, you should
00:32:05
start with your overall asset allocation and then you should intelligently locate
00:32:10
those assets to try to minimize your long-term tax drag. For example, if someone has a million dollars in each of
00:32:16
a traditional IRA, a Roth IRA, and a taxable account, and their financial plan suggests overall that they ought to
00:32:22
be something like 6040 stocks and bonds, then what they would do probably the asset locator at least would take all
00:32:29
million dollars in the taxable account and invest in stocks because stocks tend to be much more tax efficient than
00:32:35
bonds. And inside the taxable account, you know, you're going to pay some taxes. So, you'd rather pay those on the
00:32:40
tax efficient assets, the stocks instead of the bonds. So, taxable account, 100%
00:32:44
stocks. And then you're going to take all 1 million from the traditional IRA
00:32:48
account. You're probably going to invest that in bonds. Bonds are tax inefficient, but that doesn't really
00:32:53
matter inside of a traditional IRA. And then that leaves us with the Roth IRA. You still need to allocate 800,000 more
00:32:59
to stocks and 200,000 more to bonds in order to meet the overall 60/40 allocation. And you would do that inside
00:33:05
the Roth IRA. Now, the Roth IRA could technically also be a good tax shelter for the bonds, just like the traditional
00:33:12
IRA is. But all else being equal, we'd probably prefer to have our growth assets in a Roth account over a
00:33:18
traditional account because in the long run, the income tax benefit of Roth accounts means we'd probably rather have
00:33:24
that one grow really, really big because we never pay tax on it again. So anyway,
00:33:28
that's why we put the bonds in the traditional account and we try to put the rest of our stocks into our Roth
00:33:33
account. Now, this idea as I've presented it creates a little bit of a mini problem. And that problem is that
00:33:39
generally when you need to withdraw money from your portfolio to support your lifestyle and retirement, the
00:33:44
baseline order of operations is you withdraw from your taxable account first, from your traditional accounts
00:33:49
second, and from your Roth accounts last. So, I spent a lot of time diving into detail on that withdrawal framework
00:33:55
back on episode 121 and included many corner cases where the framework actually has nuance, but the basic
00:34:01
framework is taxable accounts first, traditional accounts second, Roth accounts third. Episode 121 if you want
00:34:07
to learn more. Nevertheless, most of the time for retirees, your taxable account,
00:34:11
taxable brokerage account, that's the place, the first place where we want to
00:34:14
withdraw from. But wait a second, because most of the time for most retirees, our cash and our bonds are the
00:34:21
source of our near-term liquidity. Our stocks are the source of our long-term growth. But if I'm supposed to withdraw
00:34:26
from my taxable account first, but my taxable account doesn't have any bonds
00:34:30
in it. It's just all stocks, that kind of presents a little bit of a philosophical problem. How am I supposed
00:34:36
to withdraw cash and bonds from my account in my taxable account if it's all stocks? So the short answer is yeah,
00:34:42
it's a little bit of a problem, but at the same time, it might not be a problem. It depends on how you want to
00:34:46
think about it and your comfort with numbers because the solution that is most frequently offered up is to play
00:34:51
this kind of mini shell game, but in a good way, not in a bad way, a mini shell game in your own accounts that does get
00:34:57
you to the same place where you want to be. So let's say you need $10,000 this
00:35:01
month for your retirement expenses. proponents of this idea that I'm kind of
00:35:05
going to walk you through. They would say that, yeah, you need to sell $10,000 of your stocks from your taxable
00:35:10
brokerage account and you need to move that out to your bank. That's the $10,000 you need and it's now in cash.
00:35:16
So, we're going to check that off. We've met our cash needs, but as we just
00:35:20
alluded to, you really didn't want to sell the stocks. What you wanted to do
00:35:23
was sell bonds. So, what you want to do next, though, and this is kind of the the secret sauce, is you would log into
00:35:29
or open up, I should say, one of your other accounts. Now, in my scenario, I would go to the Roth IRA, and inside my
00:35:35
Roth IRA, where I own it was what, 80% stocks, 20% bonds. I'm going to sell $10,000 worth of bonds there, and I'm
00:35:42
going to buy $10,000 worth of stocks inside of my Roth IRA. So, if we zoom out and just look across all my
00:35:48
accounts, you'd see that I sold 10,000 of stocks, but then I bought 10,000 of
00:35:52
stocks, right? I sold from the taxable account, but I bought in the Roth account. So, on net, my my stock balance
00:35:58
hasn't changed at all. Then I I did sell $10,000 worth of bonds from my Roth IRA,
00:36:03
which aligns with how I wanted to fund my near-term needs. I I wanted to sell bonds to fund my near-term needs. And
00:36:10
then if I look at the account balances themselves, the only account that went down $10,000 in value was my taxable
00:36:16
account, which fits in with my general withdrawal order of operations. My point is that it all checks out. Some people
00:36:22
call this, I think, synthetic. I created a synthetic paycheck for myself because
00:36:26
even though you could make the argument that I had to sell stocks out of my taxable account to fund my retirement
00:36:32
needs on net, if you zoom out my portfolio, really what I sold was bonds. What are the reasons not to go down this
00:36:38
slightly more complex path? And some of you listeners might be cursing me out because it might sound much more complex
00:36:44
than slightly complex. But I swear it's only just a little more complex cuz it's
00:36:48
not crazy math, but it is more math than the simple solution where every single account was mirrored. Another reason you
00:36:54
might not want to go down this path is that every single family's situation here is going to be unique because it's
00:37:00
all a function of your specific account balances. you know, my hypothetical with
00:37:04
a million dollars each in three different accounts, it's very clean, very easy to manage. So, your mileage is
00:37:09
going to vary here depending on kind of how much money you have in all your various different accounts. And then the
00:37:14
third reason you might not want to go down this path is that the tax rates really matter here. Granted, if you have
00:37:18
higher tax rates, could totally be worth thinking about, but I just ran all the numbers for a retiree who I would
00:37:24
consider to kind of be in the solid center of my audience. This is someone who might have a few million dollars by
00:37:30
the time they retire, but probably has less than $10 million by the time they retire. It's someone who might be living
00:37:35
on 10 $15,000 a month right now, but probably is not living on $50,000 a month right now. And based on those
00:37:42
numbers, I assumed state and federal tax rates, income tax, capital gains tax that would illustrate that retirees
00:37:49
scenario. And then I ran two 30-year retirement scenarios. One scenario optimizes the tax location of all the
00:37:55
assets per the rules that we just outlined a few minutes ago. And the other scenario simply locates the assets
00:38:00
in an easy 60/40 allocation across all three accounts. And both scenarios use annual rebalancing which I think makes
00:38:07
sense to get us back to the 60/40 location allocation I should say. Uh and both scenarios follow the rule of thumb
00:38:13
where we withdraw from the taxable account first, the traditional account second, the Roth account last. Now, if I
00:38:19
take all those assumptions and I look at the difference between the person who's
00:38:23
tax optimizing perfectly versus the person who doesn't care about tax optimization at all, the optimal
00:38:29
scenario saw annual returns of 6.96% per year. And then the easy button scenario
00:38:35
saw returns of 6.92% per year. Again, that was 6.96 versus 6.92, a 30-year difference of 0.04%, 04%
00:38:46
4100ths of a percent per year. Now over 30 years that compounds to a total difference of about 1.1%. And on say a
00:38:54
$3 million account that equates to about $1,200 a year. Now, as I just said, everyone's numbers are going to change
00:39:00
the outcome here. Your account size matter, the ratio of your different accounts matters, how much is taxable,
00:39:05
etc., etc. Essentially, if you're paying high tax rates on all your capital gains
00:39:09
on all your income, on all your IRA withdrawals, then uh you might care about tax location a lot. So anyway,
00:39:15
where do I land on it personally? Well, people hire me to look at this and my job is to pay attention and optimize it
00:39:21
to at least explore the second camp for my clients to at least question for them
00:39:25
whether the juice is worth the squeeze. And earlier I mentioned a number, $1,200
00:39:29
a year about a minute ago. Now, would you bend over and pick up $1,200 if it was just lying there on the ground?
00:39:35
Absolutely you would. But is setting this up as easy as bending over to pick up that money? Well, not quite. And by
00:39:41
making this a little complex, do you run the risk of maybe shooting yourself in the foot and costing yourself more than
00:39:47
$1,200 a year? Yeah, you run that risk a little bit. So, if you're a DIYer out
00:39:51
there, my simple question to you is, would you prefer a set and forget strategy that is really, really easy to
00:39:57
follow, or a strategy that, yeah, you need to pay some attention to, you need to stay on top of that's probably going
00:40:03
to save you somewhere between a few hundred and a few thousand per year? I've said it before on this very topic,
00:40:08
and I'll say it again. It's not that it's not worth doing, it's just that
00:40:11
it's not worth making it your top priority. Right? There are other dials to turn in your financial plan that are
00:40:17
certainly going to create more than 0.04% 04% per year of value. I wrote an article back in February, February 2026.
00:40:24
I'll link it in the show notes. It's called the long-term investors order of
00:40:27
operations. And basically, the whole point of the article was that some investors get intrigued by these shiny
00:40:33
objects in the world of financial planning. And they pursue those shiny objects even when there are much bigger,
00:40:39
more important objects that they probably ought to be pursuing. So my list in that article, my order of
00:40:44
operations list is an attempt to help investors prioritize which operations they ought to pursue first. And then
00:40:51
only after successfully checking off the most important operations should you then move on to the less important
00:40:56
operations. So I won't spoil all 10 items on my list, at least not in this episode. Again, the link is in the show
00:41:01
notes, but I will tell you that this whole topic of tax location or asset location, which assets go into which
00:41:07
accounts, it's number seven on my list of 10 items. There are six other really
00:41:12
important things that you want to get right before you worry about tax location, asset location. So anyway,
00:41:18
it's not that it's not important, it's just that yeah, for me it's number seven
00:41:21
out of 10 on my list. So thank you Dave for the great question. I hope you learned something and it was helpful.
00:41:26
And listeners, thank you all as always for tuning in to Personal Finance for Long-Term Investors. Thanks for tuning
00:41:32
in to this episode of Personal Finance for Long-Term Investors. If you have a question for Jesse to answer on a future
00:41:39
episode, send him an email over at his blog, The Bestin Interest. His email address is jessevestinterinterest.blog.
00:41:46
Again, that's jessevestinterest.blog. Did you enjoy the show? Subscribe, rate,
00:41:52
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00:41:59
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00:42:03
for Long-Term Investors. Personal Finance for Long-Term Investors is a personal podcast meant for education and
00:42:09
entertainment. It should not be taken as financial advice and it's not prescriptive of your financial
00:42:14
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