Limits costs help long term. But are you focusing on the right costs?

26.05.20 01:49 PM Comment(s)

From the Clipboard-Retirement-Are you focusing on the right costs?

“Costs. I read something about minimizing costs can really help improve how much your money grows.”


A conversation started this way recently someone who is concerned about having enough for retirement since the stock market was down almost 30% from its all time high (though the market has since bounced back some).


This person was correct. Morningstar, the long time respected research organization and resource for DIY’ers, had found that costs indeed do predict investment results. Now, there’s no guarantee that an investor will make money. Rather, the study was clear that a mutual fund with lower costs will outperform a similar mutual fund with higher costs. That study, through the Vanguard website, is here.


(For a simple explanation of the various costs inside a mutual fund, or exchange traded fund, see this article.)


“Is that the right ‘cost’ to focus on?” I asked.


This person had no idea what I was talking about. Most people focus on investment costs, such as management costs, but there are other, far greater costs that can drain your savings in retirement.


Sequence of return risk

Haven’t heard of this? Well, people who retired recently or will soon retire unwittingly incurred this cost if they didn’t properly plan. Essentially, when the ups and downs of the stock market occur has a huge impact on how long your money will last. Even if all of your investments are “low cost”, you can’t avoid this risk. In this video, you can see that if you’re just unlucky, you can lose 13 years of time.


(Note that this video includes some specific product promotion towards the end, but the overall concept regarding sequence of returns is still valid.)


What to do about this? It is not timing the market, as some people think. If you could accurate predict when to get and out of the markets, you’d be a billionaire already and not reading what I think. For most people, it’s about using a buffer asset to manage risk. Or taking out so little money that the ups and downs of your savings doesn’t matter (look up the 4% rule, which today is really the 2.8% rule).


I’ll address buffer assets and the 4% rule in future newsletters.


Income taxes

With the recently passed stimulus package, and potentially another one coming, the Federal government has spent a lot of money in a relatively short period of time. This, combined with the general state of government finances, has led to record budget deficits and debt levels. Consequently, income taxes are more likely to higher.


If you contributed to a tax deferred retirement account, such as a 401k, you saved taxes on your contribution. When you take out that money, you pay taxes on the original principal you put in, PLUS the earnings. Thus, even if the tax rate stays in the same pre- and post-retirement, you still end up paying more in taxes. As an hypothetical example:



$1 contributed

25% tax rate

$0.25 in taxes saved



$4 withdrawn

25% tax rate

$1.00 in taxes paid


Do you consider this a good deal? You saved $0.25 to pay $1.00 later.


Let’s consider what many think may happen - taxes go up:


$4 withdrawn

30% tax rate

$1.20 in taxes paid


By only saving in a tax deferred account for retirement, you are at the mercy of the government and whatever tax rate they choose to set. As a result, you truly have no idea how much your 401k is worth after tax because no one has any idea of what taxes will be in retirement.


What can you do? Most understand the concept of diversification in investments - stocks, bonds, cash, etc. But few think about the concept of tax diversification, as this short video discusses. You may need to save differently for retirement than what you are currently doing.


Hidden “taxes”

Beyond income tax rates, there are also hidden taxes that retirees pay. Increasing taxable income (401k withdrawals, work, rental income, etc.) can trigger taxation on Social Security benefits as well as surcharges on Medicare premiums.


What can you do? These hidden taxes are triggered by taxable income. By having tax diversification in your savings would allow you to get the money you need to live on, but keep the taxable income below the thresholds that trigger these taxes.


In all three cases, investment costs in a mutual fund or ETF have no impact, nor will a low cost mutual fund help you avoid these other costs. The challenge is to balance these factors into what works for you.


So I asked this person, “Would you be happy if you ran out of money a lot faster than expected, but paid very little in investment costs?”


“Or how about you paid a ton more in taxes and surcharges so you had a lot less to live on?”


“Would you consider either of those scenarios a success?”


I think he knew the answer. And the focus on investment costs only didn’t seem so important any more.

My content is for educational purposes only and should not be construed as advice or any kind of solicitation to buy or sell anything. As always, consult your own financial or tax professional for your own specific situation. Your mileage may vary. Batteries not included.


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