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.

Summary

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.

Staying fit on a budget; mountain biking, hiking and working out at home

On the path to FI, keeping fit is a good investment

Everyone wants to keep in good shape but it’s a challenge to find workouts that can keep us motivated and interested. Today I am going to share how I keep in shape while staying frugal towards getting FI.

Mountain biking has major advantages

If you enjoy cycling but don’t enjoy riding in traffic and do enjoy the woods, mountain biking may be for you. One of the big advantages over running is the lack of impact on your knees. Riding up 1000 feet elevation getting your aerobic workout can be followed with a thrilling descent on trails. This is one reason why I enjoy mt biking over hiking. Once I’ve put in the effort to get to the top of and see the view, I am usually only a fun 25 minute quick descent back to the car. The downhill is the reward for the climb up. And everyone can pick their chosen approach in terms of how to descend. Nowadays people tend to think of downhill mountain bikes that bomb down steep inclines. But there are plenty of winding, smooth, banked trails around that allow for fun but controlled descents.

mountain biking in the Palouse
Fast flowing downhill, the way I like it

Mountain biking can be a low expense sport

You can spend over $10,000 on a mountain bike, but you don’t have to. My mountain bike is over 10 years old and it still fits my needs. I do recommend getting a bike with quality components and I would recommend spending a minimum of about $1,500. I do plan to upgrade my bike in the next few years and will probably spend closer to $3,000. But I have kept my last two bikes for over 10 years each, and my original Specialized ‘Rockhopper Comp’ still gets used for rides on paved rail trails. So if you pay $3,000 and keep your bike for 10 years, it’s only $300 per year. Not a bad upfront cost for such a great sport.

Mountain bike maintenance

Mt bikes do require some maintenance and you can choose to have your local shop do it, or learn to do much of it yourself. The amount of maintenance does vary with your riding style, and also with the type of terrain and local conditions. When I used to ride in western Oregon where there was alot of rain and mud, I went through more components than I do now in dry eastern Washington State. The major maintenance I do myself includes changing tires and tubes, changing and adjusting disc brake pads, replacing brake and shifter cables and cleaning and lubricating the chain, chainrings and rear cassette.

Where to ride

If you are fortunate there may be an area that allows mountain biking near your home. For me the availability of a mountain biking area is a major consideration in where to live. I have two main areas I ride, but there are several within a 1 hour drive. The first ride I do is right out my door. In the Palouse there are miles of gravel roads that are great, especially for training early in the year. Later on when the roads get drier and dustier and there is more farm machine traffic (and I am in better condition), I move onto my main area. My second area has a trail system especially for mountain bikes and has about 2000 ft of elevation. This is ideal, as when trails are shared use, (for example between horses and mountain bikes) they can get rutted. If you want to see what areas are available near you check out: MTB project.

mountain biking near home
Biking from the homestead, riding up 600 ft elevation total

Hiking

Hiking is obviously a cheap outdoor activity and I like to mix it up re: hiking and mountain biking. I don’t have much to say here except that I tend to choose hiking when the weather isn’t great, or the area does not allow biking. One tip is to identify a fun hike you can do from your front door. Even when we lived in Seattle we found a 3 mile urban hike that took us up a hill for a view and was a good workout. It wasn’t a known hike, just one that we identified by doing some walking around the neighborhood and picking a route with low traffic.

Palouse hiking
There are some nice hikes in the Palouse, but please don’t tell anyone

What about exercise in the winter?

In the Palouse we do get some snow, and even hiking is not feasible at times. My approach is a nice rowing machine. I own a Concept 2 rowing machine and it works great. The workout equipment is in the basement. So if you are considering a ‘tiny house’ keep in mind some of the limitations of said house. Another approach we have for the early Spring is to drive south about 45 minutes to a town called Lewiston, Idaho. Lewiston is on the Snake and Clearwater rivers and sits in a valley carved by these rivers about 1600 ft lower than where we live. It’s thus a few degrees warmer and melts out earlier in the year. This allows early year mt biking and hiking. Maybe there’s an ‘early year area’ near you?

Early season hike in Lewiston, Idaho in March

Weightlifting

I don’t consider myself a weightlifter, but I do workout regularly with weights. The Stronglifts 5×5 site has the workout I have used for the last 4 months. I love the simplicity of it, and the Mon-Wed-Fri schedule that gives me the weekends off.

Summary

Hopefully this will provide some ideas for how to integrate more fitness into your routine. I track my workouts, hikes and bike trips in excel. I also put together an excel file that has the drive times to hikes and bike trailheads within 2h of my house, determined by Google Maps. It’s not always obvious which trailheads are the closest in terms of driving times.

Country living: Two tractors are better than one

My first John Deere tractor

When we bought the homestead we negotiated a 1969 John Deere 1020 tractor in the deal. It’s big, weighs a lot, and has a powerful bucket. When we bought it I didn’t even know if it was diesel or gas and hadn’t even ran it, just trusted the sellers that it ran and the PTO (power take off) was live. After we moved in it took awhile for me to get to evaluating it. It fired up as advertised, and the hydraulics and PTO worked, but it needed some work. The hydraulics were leaking from below the levers and the muffler needed to be patched and better attached to the exhaust manifold. Rather than buy a new muffler I just patched it with some Permatex 80333 Muffler and Tailpipe Putty. For the hydraulics, I removed the parts that were leaking and took it to my local NAPA dealer. We live in farm country and they have an extensive selection of hydraulic parts. I got the pieces I needed (after 2 trips) and got it repaired. I changed the oil and filter, cleaned the air filter, and made sure the hydraulic oil was at the right level.

How to approach mowing 8 acres?

Continue reading “Country living: Two tractors are better than one”

Frugal Living: 4 ways to reduce recurring expenses

Recurring expenses are the silent killer of Financial Independence

To get FI, the well known 25X rule says you must have saved 25 times your yearly expenses in order to be financially independent. But how many of your yearly expenses are collected on a monthly basis? If you pay a monthly fee then the rule becomes the 300X rule. 25X per year times 12 months = 300X. So if monthly, a couple has an $80 cable TV bill, a $100 cell phone bill, a $40 book bill, and a $80 coffee shop bill, that is a total of $300/month. Using the rule of 300X you need $90,000 in savings to sustain these expenses. What are your current expenses for these 4 items?

Reducing the cable TV bill

In 2010 I realized that our cable TV just wasn’t being used that often. We had a lot of channels, but rarely was there something worthwhile to watch. When we did use it, a lot of viewing was network TV. Another negative was our cable box (that we were renting) had begun to advertise to us. The solution was a home theater PC (HTPC) running windows 7 media center hooked up to an antenna. We are still using it today and even in our rural area of Eastern Washington State we get the following channels for free over the air (OTA): ABC, CBS, NBC, FOX, PBS, Justice Network, Decades, SWX sports, This TV. We supplement this with Amazon prime video and Sling TV. Amazon prime was purchased on sale for $72. I value the Amazon 2 day free shipping at over $100 per year based on the fact that the speedy shipping allows me to avoid at least ten trips to hardware stores over the course of a year to keep the homestead running. So prime video I consider free. We’ve enjoyed several movies and series like Vikings using Amazon prime video. Sling TV is $13.99 per month with our T-mobile rural internet discount and gives us access to the cable shows we were missing. The full price is $20/month. Sling isn’t perfect and during heavy viewing hours it often freezes and we have to back it up ten seconds, but it is good enough (meets Dear Wife test). Setting up a HTPC is a significant project, but an alternative is a Tivo Roamio OTA that includes a channel guide service, currently $389 on Amazon. The choice of antenna is very location specific, but let’s allocate $120 for antenna, cable and installation supplies. If we assume the setup will be in use for at least 5 years (hopefully more) we can spread the cost over 60 months: $389 + $120 = $509 /60 months = $8.48/month. So it’s possible to reduce TV to $28.48 per month (20$ for Sling TV and $8.48 for the Tivo-antenna setup) and still have access to network and also many cable channels.

Reducing the cell phone bill

On July 29th, 2017 T-mobile shows $50 per line for a couple for $100/month. Verizon shows $70/line for $140/couple/month. I would like to have data for my phone, it would be convenient. But not at that price. Instead we have an AT&T prepaid that costs $100/year per person but has no data. $200/year for two people for 12 months is $16.66 per month. Most of the time I am at home or at work and my android phone connects to the internet through wireless. When I am on the road I can often connect to free wireless. I have to admit there are times I wish I had data when I am on the road, but not for an extra $83.33 a month. We don’t talk a lot on our cell phones and the plan we have is 10 cents per minute. Adding $100 gives us 1000 minutes and a year of use. We don’t even use ½ of the 1000 minutes per year. Unfortunately, AT&T no longer lists the 10 cents a minute prepaid plan (previously called gophone) as available for our zip code, even though we are still using it. Republic wireless advertises a $15/month plan with unlimited talk, text and wifi data for $15 /month per person. Using that service would be $30/month for a couple. In that case giving up data would save $70 /month per couple.

Reducing the $40 book bill
Free books from your county library, frugal living
Overdrive software on my android phone downloads audiobooks from the county library for free. The audio CD version is $34.92 or $16.99 for Kindle. My price, free.

If a couple each buy two $10 books per month that generates a $40/month book expense. To me that’s quite reasonable, but there’s a little known secret to reduce this… the library. I work at a university and can take a 10 minute break and walk over to the university library. I also have a county library card that gives me access to the county library electronic collection. These two services save us over $360 per year. The university library is great for harder to find nonfiction books the DW enjoys. It has a service called Summit that accesses other university libraries. Our university will allow local non-university-employed people to use its library. Our county library has an electronic collection that allows me to download audio books onto my android, or electronic books onto my Kindle… for free. We average about 3 free books per month. Most audiobooks are more than $10, so we save at least $30 /month. We still buy about 12 books per year for books that are either not available from the library, or we just prefer to own them. The great thing about the county library is after you make a trip to get your library card, there is no need to make a trip to the library to access the digital library. Just log in from home and download the titles. I haven’t been to the county library in over 8 years, but I’ve downloaded over a thousand dollars worth of audiobooks. Utilizing the library can easily save $30 /month.

Reducing the 80$ coffee bill
Starbucks coffee at home, frugal living
Psst, you can have Starbucks coffee at home.

This is the cliché money saving approach, but it is a simple one many people can use. One day driving by a Starbucks early in the morning I saw a line of 6 cars. I wondered, are those people’s coffee experience really worth it? Are they spending their money to get value? I can make a cup of good drip coffee at home for less than 30 cents, and I don’t have to wait for 5 cars ahead of me to order. While I enjoy a coffee out once in a while, I really don’t need it on an ongoing basis. I tend to go out for coffee twice a month, and DW almost never does. So we pay about $10 a month. Savings, about $70 a month over going out regularly.

Progress to FI

Using the above examples the monthly totals are: Cable TV $28, 2 cell phone plans $30, books $10, Coffee $10 for a total of $78 per month. Using the 300X rule you would now only need $23,400 to cover these expenses. You are now $66,600 closer to FI ($90,000 – $23,400).

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