Getting started on the path to Financial Independence (FI)

It’s never too late to get started towards FI

In the Get FI article I outline the reasons to get FI, and 5 major steps to get there. Here I outline getting started on financial independence.

Getting Started on Financial Independence
Be wise with your recurring expenses and investing costs
Evaluate recurring expenses and cut them mercilessly

Do you know all your recurring monthly expenses? Are they all necessary? If not, do they provide enough value to justify their cost? By thinking carefully about just 4 items; cable TV, cell phone, books and coffee I showed how to reduce expenses by $222 per month. What expenses can you reduce or eliminate? Do you need to buy the latest video games or can you play older titles that cost 1/3 as much? Are you using your gym membership? Everyone is different here. If you have a golf membership and use it twice a week that may provide good value, but if you have a gym membership and use it twice a month…. Be ruthless and think outside the box. If your hair style is a number 3 buzz cut, can your spouse cut your hair? How much would that save per month, year, and ten years? Keep going until you have gotten to a balance where you feel confident each monthly expense provides enough value compared to the freedom it would give you once you are FI if you cut it.

Take advantage of free money from your employer

Does your 401k or 403b provide a match? Contribute at least enough to capture the employer match. By cutting recurring expenses you might free up enough $ to allow you to match your employers contributions.

Identify your investing costs

If you have a 401k plan /403b and or a traditional IRA what are the expense ratios (ERs) and what is that costing you a year? The expense ratio is what it costs you to hold the fund. For example if you have a balance of $100,000 and an expense ratio of 1% you are paying $1,000 a year. Expense ratios can vary greatly for mutual funds within retirement plans. For example my employer provides a 403b plan from TIAA-CREF. There are many investment choices but let’s look at:

a) an all-in-one fund:

TIAA-CREF Lifecycle 2030 Fund (Institutional). Symbol: TCRIX. Expense ratio (net): 0.42% (as of August 2017)

From the TIAA CREF website: “The Lifecycle 2030 Fund seeks high total return over time through a combination of capital appreciation and income. Each of the TIAA-CREF Lifecycle Funds is designed to provide a single diversified portfolio managed with a target retirement date in mind. The target date is the approximate date when investors expect to begin withdrawing money from the Fund. Each portfolio invests in several underlying equity, fixed-income and direct real estate funds. Currently, the Lifecycle 2030 Fund’s target allocation consists of an equity/fixed-income/direct real estate mix of approximately 69.6%/27.9%/2.5%.

b) an equity (stock) account:

CREF Stock Account (R3) Symbol: QCSTIX. Estimated expense ratio 0.32% (as of August 2017)

This variable annuity account seeks a favorable long-term rate of return through capital appreciation and investment income by investing primarily in a broadly diversified portfolio of common stocks. Under normal circumstances, the account invests at least 80% of its assets in broadly diversified portfolio of common stocks.

c) an international equity account:

CREF Equity Index Account (R3). Symbol: QCEQIX. Estimated expense ratio 0.33% (as of August 2017)

From the TIAA CREF website: “This variable annuity account seeks a favorable long-term rate of return through capital appreciation and income from a broadly diversified portfolio that consists primarily of foreign and domestic common stocks. Under normal circumstances, the account invests at least 80% of its assets in equity securities of foreign and domestic companies.”

d) a bond account:

CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29% (as of August 2017)

From the TIAA CREF website: “This variable annuity account seeks a favorable long-term rate of return, primarily through high current income consistent with preserving capital. Under normal circumstances, the account invests at least 80% of its assets in a broad range of fixed-income securities. The majority of the account’s assets are invested in U.S. Treasury and other governmental agency securities, corporate bonds and mortgage-backed or other asset-backed securities.

These costs, 0.42% for the all-in-one fund, or 0.32%, 0.33% and 0.29% for the equity, international equity and bond accounts respectively, are not considered high by industry standards. In fact before I understood the impact of costs, I used to own funds with even higher expense ratios. But let’s look at what the 0.42% expense ratio will cost for an investment of $10,000 over a 25 year time frame. We will use the Vanguard cost tool here with the default setting of a 6% average annual return.

After 25 years, 89% of the funds returns would be kept, $87,568.97, and 11%, $10,778.09 would be lost to expenses. Ouch.

Is there a lower cost alternative?

In the Bogleheads and the Three Fund Portfolio article I discuss a low cost (0.1542% expense ratio) Three Fund Portfolio approach using Vanguard funds. But what if your employer does not have Vanguard funds? It turns out my TIAA-CREF plan does have lower cost choices for:

a) equities

TIAA-CREF Equity Index Fund (Institutional) Symbol: TIEIX, Expense ratio (net): 0.05% (as of August 2017)

From the TIAA CREF website: “The fund seeks a favorable long-term total return, mainly through capital appreciation, by investing primarily in a portfolio of equity securities selected to track the overall U.S. equity markets based on a market index. It normally invests at least 80% of its assets in equity securities within its benchmark index.

b) international equities

TIAA-CREF International Equity Index Fund (Institutional) TCIEX: Expense ratio (net): 0.06% (as of August 2017)

From the TIAA CREF website: “The fund seeks a favorable long-term total return, mainly through capital appreciation, by investing primarily in a portfolio of foreign equity investments based on a market index. It normally invests at least 80% of its assets in securities within its benchmark index.”

So a Three Fund Portfolio can be built using TIAA-CREF equity funds and their bond account:

TIAA-CREF Equity Index Fund: TIEIX. Expense ratio: 0.05%

TIAA-CREF International Equity Index Fund (Institutional) TCIEX. Expense ratio: 0.06%

CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29%

So for a 30 year old who uses the age in bonds formula with 20% of stock funds in international for a Three Fund Portfolio, the TIAA CREF Three Fund Portfolio would be:

30% in CREF Bond Market R3. Symbol QCBMIX. Estimated expense ratio 0.29%

56% in TIAA-CREF Equity Index Fund, TIEIX. Expense ratio: 0.05%

14% in TIAA-CREF International Equity Index Fund, TCIEX. Expense ratio: 0.06%

With this weighting the overall expense ratio would be: 0.0982%

Let’s look at how the 0.0982% expense ratio compares to the 0.42% expense ratio from the all-in-one fund for an investment of $10,000 over a 25 year time frame. Again, we will use the Vanguard cost tool here with the default setting of a 6% average annual return. We have to round .0982% to .011% as the tool does not accept .0982% and the next setting available after rounding up to 0.1% is 0.11%:

After 25 years:

For 0.42%, 89% of the funds returns would be kept, $87,568.97, and 11%, $10,778.09 would be lost to expenses.

For 0.11%, 97% of the funds returns would be kept, $95,409.70, and 3%, $2,937.36 would be lost to expenses.

So you would save $10,778.09 – $2,937.36 = $7,840.73 in expenses

But wait a minute, the all-in-one-fund is different than the Three Fund Portfolio

Yes it is and it might perform better, or it might not. But it will cost more in expenses.

Thinking of your portfolio as a whole may allow you to cut costs further

The CREF Bond account QCBMIX, in the TIAA-CREF Three Fund Portfolio above has the highest cost of the three funds, an expense ratio of 0.29%. But what if you had a Traditional IRA account at Vanguard in your portfolio and you could keep your bond allocation there, and hold only your US equity and International equity funds in your TIAA-CREF 403b? Then your three fund portfolio might look like this:

30% in Vanguard Total Bond Market Fund (VBMFX). Expense ratio 0.15%

56% in TIAA-CREF Equity Index Fund, TIEIX. Expense ratio: 0.05%

14% in TIAA-CREF International Equity Index Fund, TCIEX. Expense ratio: 0.06%

Then your weighted expense ratio would be: 0.0814%, even better.


Two first steps you can take on the path to FI are to 1) mercilessly reduce recurring expenses and 2) determine your investing costs and take steps to minimize them. It’s a good idea to develop an investment policy statement before making any changes to a portfolio. Note that buying and selling funds in a taxable account can trigger taxes. Let’s look at a summary of the investment costs from the three options above:

Portfolio type Symbol(s) and % of portfolio ER Cost of a $10,000 investment over 25 years*
TIAA-CREF all-in-one fund TCRIX (100%) 0.42% $10,778.09
TIAA-CREF 3 fund portfolio QCBMIX (30%) TCIEX (56%) TIEIX (14%) 0.0982% $2,937.36
TIAA-CREF/Vanguard 3 fund portfolio across retirement accounts VBMFX (30%) TCIEX (56%) TIEIX (14%) 0.0814% $2,409.52

*expense ratios were rounded up to the closest higher value the Vanguard cost calculator provided. For 0.0982%, 0.11% was used. For 0.0814%, 0.09% was used.

Harvesting free long term capital gains

In the Get FI article I list minimizing taxes as a means to speed up the time to financial independence. One mechanism to minimize taxes is to harvest free long term capital gains. In 2016 if you were in the 15% tax bracket you could harvest long term capital gains and pay zero in taxes. How cool is that? For a married couple filing jointly in 2016 the 15% bracket was $75,300. Note that if you are reducing your income by contributing to a 403b, a 457, an HSA and traditional IRAs, a married couple may be able to get to the 15% tax bracket even with a six figure income.

How does harvesting gains work?

Let’s say you had bought Vanguard Total Stock Market (VTSAX) for $20,000 in 2014. In 2016 if it was hypothetically worth $30,000 you would have a basis of $20,000 and $10,000 in unrealized long term (> 1 year) capital gains. If you don’t ‘harvest’ then at some point you may have to pay taxes on your gains. By harvesting the gains you can reset your basis higher, thus potentially lowering future taxes. If after selling the fund and harvesting the $10,000 (which counts towards your income) you are still in the 15% tax bracket, you get a ‘step up in basis’ for free.

Why is it important to harvest free gains?

If you increase the cost basis of the mutual funds in your taxable account by harvesting gains, when you ultimately sell them in the future, you may lower your tax. Free money is good. Also if they lose money after you increase the basis and you sell them in a later tax year, you can harvest a tax loss. After you retire early, you might use a harvested loss to increase the amount you convert from a traditional IRA to a Roth by up to $3,000.

How I messed up in 2016

I have a confession. I didn’t take full advantage in 2016. It turns out I could have harvested an additional $12,000 in gains… I didn’t understand that standard deductions can increase your harvest because of how your income ‘stacks’. Michael Kitces explains the mechanics here. Since 2016 has come and gone it’s too late for me to sell and harvest for 2016. However I went back to my 2016 return and manually changed a long term capital gain in TaxAct software and found out I could have harvested another $12,000 in gains before my income tax increased. Oops.

There are caveats
  • You only get the free harvest on long term capital gains (held longer than one year), not on short term gains.
  • The gains you harvest count towards your income, and thus affect how much you can harvest for free.
  • Harvesting capital gains can impact state taxes. Since I live in Washington State which has no state income tax, that doesn’t affect me.
  • If you buy a different mutual fund like I did after you harvest your gain you may realize an unqualified dividend on the new fund you buy, that you have to pay taxes on. Thus if you’re going to sell and buy a different fund, avoid buying within 61 days of a dividend distribution so that the dividend is qualified. For Vanguard funds that pay dividends quarterly that means you can harvest a few days after the distribution and buy the other fund more than 61 days before its distribution date. For example in 2016 Vanguard Total Stock Market Admiral Shares (VTSAX) and Vanguard S&P500 (VFIAX) had their distributions on Sept. 9th. Using the example above one could have sold $30,000 of VTSAX shares that were long term with a basis of $20,000 on Sept 12th, 2016 and bought $30,000 of VFIAX thus harvesting $10,000 in capital gains. The next distribution date for VFIAX was December 20th, 2016 so the dividends from the new purchase would be qualified if you held the fund for more than 61 days. I realize that VTSAX and VFIAX are not equivalent, but they track so closely that for me, I am comfortable holding either.
  • This is a big one. Harvesting long term capital gains interacts with other income events such as a Roth conversion or dividends, so make sure you understand the big picture. For 2017 I used tax software to estimate how much I can harvest for free, rather than trying to calculate it by hand.
  • You have to harvest within the tax year. You cannot wait till the next year after you know your exact income to find out exactly how much you can harvest.
  • If you purchase health insurance using the ACA (Obamacare), harvesting gains can increase your income and therefore decrease subsidies.
Moving forward to 2017 harvesting

For 2017 I modeled my expected income and predicted the maximum capital gains that I could harvest for free using the 2016 version of TaxAct Plus. Based on this modeling I have already harvested long term capital gains for 2017. When I do my 2017 income taxes in early 2018 I will know my exact income and see how close I came to maxing out my harvest of free long term capital gains. But I will definitely have done better than 2016 where I left $12,000 on the table. As you can see from my 2016 mess up I am no tax expert, so consult a tax professional for your situation.

harvesting capital gains
Harvesting garlic is easier than harvesting capital gains, but it’s not as lucrative

Bogleheads and the Three Fund Portfolio

The Bogleheads can help you invest wisely

In the Get FI article I mention several resources for investing wisely including the excellent book “The Bogleheads’ Guide to Investing

The Bogleheads are a group whose name honors Jack Bogle. Mr. Bogle has been a champion of the individual investor and a pioneer of index mutual funds. The Bogleheads maintain an investing wiki and a forum for investing advice and discussion.

The Bogleheads wiki

The wiki is a great place to educate yourself if you want to get FI. Where to start? The getting started page. As you start to learn the basics you will eventually come across the “Three Fund Portfolio”:

Investing with the Three Fund Portfolio

You pick three index funds; a total US stock market index fund, a total US bond index fund and a total international stock market index fund. If you are using Vanguard funds the three funds are:

Vanguard Total Stock Market Index Fund (VTSMX)

Vanguard Total International Stock Index Fund (VGTSX)

Vanguard Total Bond Market Fund (VBMFX)

You then pick an asset allocation which is individualized. For example you could decide you want to have your age in the bond fund VBMFX. Then 100 – (your age) will be in the stock funds VTSMX and VGTSX. Next you decide what percentage will be US (VTSMX) and what percentage will be international (VGTSX). There is some disagreement among experts here. My approach is to have 20% in international. So what would this look like for a 30 year old?

Age in bonds would be 30% in the bond fund VBMFX

Then 100% – (30%) is 70% in the stock funds VTSMX and VGTSX

Of the 70% in stock funds 20% (20% of 70% is 14%) of the total is in international (VGTSX)

Of the 70% in stock funds 80% (80% of 70% is 56%) of the total is in US (VTSMX)

So for a 30 year old who uses the age in bonds formula with 20% of stock funds in international:
Three fund portfolio
30% in VBMFX

56% in VTSMX

14% in VGTSX

The Three Fund Portfolio wiki has more info, and if you have any questions you can ask them in the Bogleheads forum. Selling investments in a taxable account to set up a Three Fund Portfolio may incur taxes. So make sure you understand any tax implications.

Low costs matter… a lot

The costs of the Three Fund Portfolio from Vanguard are the ‘Expense Ratio (ER)’. The three funds currently (July 2017) have expense ratios of:

VBMFX: 0.15%

VTSMX: 0.15%

VGTSX: 0.18%

It is important to understand you pay these fees every year regardless of whether the funds increase in value. In the above example the overall ER for the portfolio is 0.1542%. For comparison, an all-in-one fund from Vanguard that has 25% in fixed income and 75% in equities, Vanguard Target Retirement 2030 Fund (VTHRX), has an ER of 0.15%, basically the same. I found an all-in-one fund from a well-known competitor that has an ER of 1.42%. That is more than 9 times as expensive as either the Vanguard Three Fund Portfolio or the VTHRX all-in-one fund. Does it really make a difference between 0.15% and 1.42%? Yes, over a long time span it makes a huge difference. If we estimate returns on a $10,000 investment over 25 years using the default 6.0% yearly return from the Vanguard cost calculator we see that with a 0.15% ER we end up with $94,362.22. At a 1.41% ER (the calculator does not accept 1.42%) the returns are $66,347.98. A difference of $28,014. Since one will likely be contributing constantly over this 25 years, the differences will likely be much higher. Now imagine 25-year-old you walks up to 50-year-old you with a suitcase containing $28,014 cash. Thank you very much for paying attention to costs, 25-year-old you.

So why not just use VTHRX and keep it even simpler?

Actually that is a perfectly good solution and one that might be best when starting out, particularly since the minimum investment for VTHRX is only $1,000. But there are 2 major advantages to the Three Fund Portfolio.

First, once your assets grow you can move from the ‘Investor’ class to the ‘Admiral’ class of the three funds that have lower ERs. The Admiral class funds have higher minimum investments:

Vanguard Admiral Funds

In the Three Fund Portfolio example above the overall ER for the portfolio with Admiral class funds would now drop to 0.0528%. If we plug that into the Vanguard calculator (use 0.06% as we cannot plug in 0.0528%) we see we can save even more, now we would have $96,734.46 after 25 years. So we save another $2,372. Again I’m pretty sure 50-year-old you will thank 25-year-old you for the extra $2,372.

Second, the Three fund portfolio allows you to better organize your portfolio for tax efficiency. You can keep bond funds in tax-advantaged accounts (Roth, Traditional IRA, 401k, 403b) and equities in taxable accounts which allows you to tax harvest losses and also tax harvest gains. This is complex and we won’t delve into it here. If you are just starting out it is fine to go with a low cost, all in one fund like VTHRX and worry about improving tax efficiency later.

Will a more expensive, actively managed fund outperform the Three Fund Portfolio?

The short answer is it might, but probably not. The Three Fund Portfolio is comprised of index funds that do not attempt to beat the market, only capture its returns. Rick Ferri and Alex Benke compared a Three Fund Portfolio to actively managed funds and found that the Three Fund Portfolio outperformed 82.9% of active funds over a 16 year period. See their white paper.

But I saw an advertisement for a fund that consistently beats the S&P500

See survivorship bias.

The investment policy statement (IPS)

An IPS, described here, is basically a set of rules you set for yourself to help you ignore market volatility and capture market returns over a long investment horizon. If you don’t have an IPS, maybe a month after setting up the Three Fund Portfolio the stock market gets hot. You decide you want to increase your stock holdings and change to an age – 10% in bonds formula to increase equity exposure. You sell some of your VBMFX and buy VTSMX and VGTSX. Then 2 months later there is a market correction and stocks go way down. Now having seen your portfolio drop in value you decide it wasn’t such a great idea to have age -10% in bonds, and you want to go back to the more conservative age in bonds formula. So you sell VTSMX and VGTSX and buy VBMFX. Congratulations, you have now just bought high and sold low. This is why many people never capture the returns of the market, they let emotions control their investment decisions. The IPS is a mechanism to keep you on track through good markets and bad. It’s a way to formalize your asset allocation and remove emotion from investing. As Mr. Bogle often says “Stay the course”. Your IPS can help you stay the course.

My thoughts

Once you embrace the idea that you won’t try to beat the market, just capture its returns with low cost, you are ready for the Three Fund Portfolio. There are more complicated portfolios that may or may not do better. But the simplicity of the Three Fund Portfolio can be valuable, particularly if a spouse without much investing knowledge needs to take over at some point.

Let’s get FI

Financial independence (FI) versus retirement
Financial independence and sunsets
Sunsets are better with FI

When I finished graduate school I knew I had to learn something about finance. I bought the obvious, “Personal Finance For Dummies” by Eric Tyson. It turned out to be a great starter finance book. From this book I set a goal of being able to retire in 20 years. It seemed a pipe dream at the time. In retrospect if I knew then what I knew now, I would have set the goal of 15 years. After a lot of reading and podcasts I have come to understand that retiring to a life of only leisure is probably not for me, I’d like to have a creative outlet that earns money. Don’t get me wrong I like leisure, just not 100%. So for me the goal is financial independence (FI), not retirement.

Why get FI?

Work can be unpredictable. One day things are going great, then next you get an email from your Boss saying “Can you meet this afternoon, we need to make some changes and it will include (fill in the blank – really bad stuff)”. Or maybe you’ve been working very hard for 20 years and you start to run out of gas, it happens. Or maybe you have a serious health issue. The bottom line is things can go bad fast, and very unpredictably. It’s nice to have financial security.

FI also improves the dynamic at work. As you start to reach FI your philosophy at work changes. People who are not close to FI and have large mortgages often don’t speak up and don’t take risks. Being close to FI can give you the freedom to do the job the way it should be done.

Notice the word freedom in the previous sentence. FI is freedom. Once you are FI you are no longer a wage slave. You have choices. This is the main reason to be FI, to increase your freedom. Who doesn’t want to have more freedom?

Freedom, here I come, let’s get FI

Below are 5 major steps to FI. If I could go back in time I would have educated myself about these steps and made them a major priority. There are also links to resources to get you started.

  1. Reduce expenses and spend thoughtfully. Money is just a way to trade your skills and efforts for goods and services you need. If you think money is bad or something you should not think about, then you really are not valuing your skills and efforts. So as money comes in, it’s important to make sure you are getting value for every dollar that goes out. Don’t trade your life energy for consumer goods that you will seldom use and will end up in a landfill in 10 years. Do spend on life experiences and things you truly value and will ‘move the needle’.
  1. Have a high savings rate. You may read that you should save 10-15% of your salary for retirement. I suggest a better approach, save at least 50% for FI. This may not be possible when you are just out of school, but it should be a goal to get there. As you get closer to FI some people even get to 75%. The time to FI is directly related to your savings rate. At 10% you have 51 years till FI, at 15% you have 43 years, at 50% you have 17 years and at 75%, 7 years. Having a high savings rate means being creative and really stretching a dollar, but it can be fun.
  1. Invest wisely. Ok this is obvious, but here’s where many people go wrong. They offload the understanding of investing to someone else or just go with the recommendations of their 401k pamphlet (like I did). My belief is that everyone should have a thorough understanding of investing. It’s about valuing your own time and effort. This means learning the basics and reading at least 2 books on personal finance/investing. There are many excellent resources available. Investing includes understanding 1) different asset classes like equities, bond funds and cash, 2) your risk tolerance and determining an appropriate asset allocation, 3) the powerful effect of expenses including mutual fund expense ratios on your timeline to FI, and 4) how to construct an investment policy statement that will guide you through good markets and bad. Go forth and educate yourself.

The Bogleheads’ Guide to Investing

The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments

  1. Minimize taxes. I learned the hard way there are a lot of strategies that can be used to minimize taxes. I am not talking about sketchy tax deductions. I am talking about straightforward approaches like maximizing your 401k/403b and other mechanisms including 457 and health savings accounts (HSAs). For some people it is possible to contribute to a 403b, a traditional IRA, a 457 and a HSA. Justin at the Root of Good blog shows how his family was able to have income of $150,000 and pay $150 in taxes. While not everyone can save that much, many people can improve their tax efficiency. There are also approaches like tax loss harvesting and tax gain harvesting. If you don’t know what these are, you may be missing out on major tax savings. Another example is rolling over money from a 403b or traditional IRA to a Roth IRA in years where you don’t have much income. Finally, structuring your portfolio for tax efficiency is important. Unfortunately some of this is quite complicated and requires quite a bit of reading. But it can really pay off.

$150,000 Income, $150 Income Tax

Tax-efficient fund placement

Tax-Gain Harvesting

  1. Understand how to sequence withdrawals. If you can optimize how you will withdraw funds once you are FI, you can reduce the $ number you need to reach FI. This is a highly individualized process and there is a lot to learn. For example understanding how to optimize social security (SS) can have a major impact on your finances. For many couples having the higher earning spouse delay taking SS until age 70 can have a major impact.

Control Your Retirement Destiny: Achieving Financial Security Before The Big Transition

Climbing The Roth IRA Conversion Ladder To Fund Early Retirement


If this seems overwhelming, don’t worry it’s doable. Just get started. I have put them in the order I think is most important. And nowadays there are incredible resources of which I have listed my favorites.  If you are at the beginning of this journey it seems to go very slow at first. But some steps synergize with each other. Reducing your expenses allows you to contribute more to your tax deferred accounts and have a higher savings rate. This in turn allows you to minimize taxes. As your assets grow, your journey to FI speeds up. “The most powerful force in the universe is compound interest” – Albert Einstein. So get FI!