A possible change in tax law would cut the number years our IRAs that we leave to our children or other heirs will grow tax free. The change, described here, would require that our IRAs be fully distributed within ten years of our death. Under current law my IRA that I leave to an heir could easily exist for 30 years after I’ve died. Some part of my first contribution to my IRA in 1981 grows tax-free for 80 years! That part will have grown by 256X in real spending power. This post explains how under current tax law I get 80 years of tax-free growth on my first contribution to my IRA in 1981.

Last week I discussed the two basic advantages of IRAs.

• You get to play the game of different tax rates. A difference in your marginal tax rate 1) when you contribute and 2) at time you withdraw can mean you net more to spend than if the marginal rates were the same at both those times.

• Your IRA nets you more to spend than the alternative of keeping it invested in a taxable account because you are avoiding taxes – primarily capital gains taxes – for all the years your contribution is in your IRA. Each withdrawal from your IRA ends that tax-free run on that amount.

I calculate that tax-free growth is the greater benefit of the two, and I focus on this effect in this post. I’ll address the issue of marginal tax rates that heirs may pay from greater annual distributions (over 10 years vs. 30 or more years) – which seems to have alarm bells ringing for some – in the next post. The immediate question to answer:

• How do I get an 80-year run of tax-free growth on some part of my first contribution to my IRA in 1981 and what happens to it over time? We’ll follow what happened to that first contribution in 1981– the bottom layer in my total IRA – in this post. You’ll get the idea of what happens to all the other contributions.

== My first 33 years of tax-free growth ==

I made my first contribution – $2,000 – to my Traditional IRA in 1981. My 1981 contribution grew tax-free for 33 years to 12-31-14 before I was first required to withdraw a part in 2015 for my Required minimum Distribution (RMD).

I know invested my 1981 contribution in a stock fund that returned no less than the index fund VFIAX – one of the few that existed in 1981. Using VFIAX as the measure, my $2,000 in 1981 was about $71,400 on 12-31-14. That’s a combination of real growth and inflation. Let’s drop inflation and state all future dollar values in the constant dollar spending power of 12-31-14.

== RMD and the next 17 years ==

My first four years of RMD. My first RMD of 3.66% in 2015 was based on the value of my IRA on 12-31-14. My four RMD withdrawals have averaged about 3.8% per year. Real returns on my portfolio have averaged 5.9% per year. (If you follow the investment advice in Nest Egg Care, that also would have been your real return.) My portfolio has grown in real spending power by 2% per year and was 8% greater on 12-31-18. The $71,400 on 12-31-2014 increased in real spending power to $77,300 by 12-31-2018.

The balance of my lifetime. At expected return rates for stocks and bonds and my low investing cost, my IRA will continue to grow in real spending power for about the next ten years. I described this in this post: RMD percentages are less than the 6.34% expected real return rate for my portfolio through 2028. In 2029 – my age 84 – the 6.45% RMD percentage – first exceeds the expected return on my portfolio.

At the end of 2030 the value of the remaining part of my 1981 contribution to my IRA is $86,800 measured in 2014 spending power. That’s +20% from 12-31-14.

== The next 30 (or more) years ==

Let’s assume I name a non-spouse heir as beneficiary of my IRAs. I’m simplifying here; of course Patti is the first beneficiary of my IRA, but let’s assume I leave it to a non-spouse heir.

Assume I die at age 85 in 2030. My IRA passes to an heir age 55. My IRA is then subject to an RMD schedule that is different from my RMD schedule. Her RMD applies to both Roth and Traditional IRAs, ending the run of tax-free growth on the amount withdrawn.

In the first year she must withdraw based on her Life Expectancy Factor from that table: 29.6. That translates to an RMD of about 3.4% (1/29.6) in 2031. That’s about half the percentage I took the year before. Her RMD in future years calculates by subtracting 1 from her starting 29.6 Life Expectancy Factor. Her RMD percentage increases fairly steeply each year. It first exceeds the 6.34% expected return in 2045 when she is 69. My IRA is fully depleted in 2061, 80 years after its start.

At expected returns my heir will see my IRA increase in real value to $112,100. That’s 57% more than on 12-31-14 – 30 years earlier. In this example, some part of my initial contribution has ridden 80 years tax-free growth at 7% annual returns: that’s eight doublings or real grown in spending power of 256X. Whew! All this from one $2,000 contribution in 1981!

If I left my IRAs to a younger heir, that heir would see more years of real growth in my IRA and my IRA would be depleted after 2061. If my heir was age 30 at my death, my IRA would run 55 years to 2086! A total of 105 years. That is more than ten doublings for some part of my initial $2,000: far more than 1024X in real spending power.

Conclusion: A possible change in tax law could limit the number of years that an IRA we leave to an heir can grow tax-free. An inherited IRA would have to be fully distributed within ten years. This post explains how under current law my IRA could exist 30 years or more (!) after my death and for a total of 80 or more years: a part of the $2,000 I contributed in 1981 grows tax-free for 80 years. At expected return rates some part of my initial contribution will increase in real spending power by a factor of 256X.

Does it ever make sense to not add to your IRA when you have money saved that you won’t spend for many years? My friend Jim, years younger than I am, asked me, “I have money to invest. I don’t plan on spending it for many years. I’ve contributed to my IRAs for years, and I have a healthy amount now. I’m thinking I should stop putting more into my IRAs and that I should just keep it invested in my taxable account. Does this make sense?”

I used to be confused about this: I thought my Traditional IRA was converting what would otherwise be taxed as capital gains to income taxes. That is not correct. The  answer – with one remote exception – is to ALWAYS put as much into Retirement Accounts as possible. You ALWAYS gain the fundamental advantage of a retirement account relative to a taxable account: you AVOID capital gains taxes on the growth of your investment for as long as you keep it in your IRA. The purpose of this post is to explain this fundamental advantage.

== Two types of IRAs are basically the same ==

Many folks are not clear on this, but as I mentioned in this post, a Roth IRA and Traditional IRA are essentially the same. You either pay income tax when you contribute (Roth IRA) or you avoid paying tax when you contribute but then pay the tax when you withdraw (Traditional IRA). You wind up with the exact same net amount from either type of IRA if your marginal tax rate when you contribute matches the marginal rate when you withdraw. This example shows that a  $5,000 invested in a Roth IRA or a Traditional IRA net the exact same amount for spending.

== The game of different marginal tax brackets ==

The two don’t give the exact same spending power if the marginal tax rate when you contribute differs from the one when you withdraw. You play this game when you choose which kind of IRA to contribute to based on your view of the marginal tax rate when you (or your heirs) withdraw the money for spending.

• Roth over Traditional: You’d pick Roth if you are in a low marginal tax rate now and think you’ll be in a higher one when you withdraw it from your IRA for your spending. Example: your marginal tax rate now is 12%, and you withdraw it for spending when your are in the 22% bracket. You’ll win the game by paying income tax now at a 12% rate and not at a 22% rate.

• Traditional over Roth: You’d pick Traditional if you are in a high marginal tax bracket now and judge you will be in a lower one when you withdraw. Example: you’re in a 22% marginal bracket now and withdraw it for spending when you are in a 12% bracket. You’ll win the game by not paying 22% income tax now but paying 12% later.

You don’t win much in this game if the differential in marginal tax bracket is small. If the current tax rate is 22% but is 24% in the future, Roth results in about 2.6% more to spend than Traditional.

You win most when your marginal tax rates are very different when you contribute and when you withdraw. Using our current tax rates, the difference in adjacent marginal tax brackets could be 8 or 10 percentage points: 12% vs. 22%; 24% vs. 32%. Here’s a summary of what you might win (or lose) in this game:

== The 13% benefit from avoiding capital gains taxes ==

You ALWAYS win from IRAs because you AVOID capital gains tax on the growth of the amount you’ve invested and held for many years in your IRA.

To understand the benefit of avoiding capital gains taxes, I’m going going to exclude the game of different marginal tax brackets. I’m going to assume our player, Carl, nets the same from either Traditional or Roth when he withdraws. That makes it clearer to understand the benefit of avoiding capital gains tax: we calculate the capital gains tax effect as if we had invested in a Roth IRA. It’s the same effect as for a Traditional IRA, but it’s easier for our brains to understand the effect when our IRA is expressed as a Roth IRA.

Carl is 45. He has $2,000 – after paying his income taxes – that he can invest. He puts $1,000 in his taxable account to grow in the future. He puts $1,000 into his Roth IRA. He will hold these two accounts for 20 years and then sell the securities for his spending.

I’ll assume Carl invests solely in stocks with essentially zero investing cost (He’ll invest in an index fund.) and earns the expected 7.1% real return rate over two decades. That simplifies our math: we’ll consider that as two doublings or growth of a factor of four. I’ll assume Carl’s 7.1% growth in his taxable account is solely price appreciation. He only pays capital gains tax in the year he sells the stocks for his spending.

How much more does Carl have from his Roth IRA? Carl nets about 13% more for spending from his IRA than from his taxable account. This is the smallest advantage from an IRA than I can calculate, and it’s more than from winning the game of different marginal tax rates.

== It’s really more than 13% ==

I calculate that the benefit is greater than 13% more to spend with more years and different assumptions.

1) If I stretch the holding period to 30 years the benefit grows to 15%.

2) If Carl pays capital gains each year for 20 years on the 7% annual increase – not just in the 20^th year on the total accumulated growth – he’d net over 20% more from the IRA. That nip of taxes on each year’s growth in his taxable account means there is less to compound.

3) The real capital gains tax rate is greater than 15% because the cost basis is not adjusted for inflation. The effect is that Carl pays capital gains tax on the inflation portion of any dollar gain. Example: even with no real growth in the value of his initial $1,000, Carl would record a taxable gain of +$600 on his initial $1,000 from inflation at 2.5% per year for 20 years. After paying the tax, he’d wind up with less spending power than he started with. I calculate the real capital gains tax rate is 17%, not 15%, for that 20 year period. That makes the benefit of the IRA about 15%.

4) The capital gains tax rate may  be greater because of state taxes. I live in Pennsylvania. I pay 3% on capital gains. The total capital gains rate then is 18%. But I pay no tax on any withdrawals from IRAs.

== Avoid Capital Gains tax for many decades ==

I made my first contribution to my Traditional IRA in 1981, and it grew for 30 years before I withdrew any for our spending – I was first subject to RMD 34 years later in 2015. I’ll die with a balance in my IRA. My IRA is almost solely Traditional. RMD percentages will never deplete it. And I don’t have an incentive to withdraw more than RMD for our spending. Sales of securities from our taxable account will alway have the lowest tax cost and net more for us to spend (or gift) in our lifetimes.

== The one wrinkle for Jim to consider ==

If my friend Jim thinks his IRA is large now, it will only be larger in the future at expected returns for stocks and bonds. That means he may have a very large RMD in the future and fall into a higher marginal tax bracket. Jim could lose the game of different marginal tax rates.

Jim has a number of years for his current portfolio to grow before he takes his first RMD. As I discuss in this post, your RMD roughly doubles from age 70½ to age 83 at expected return rates. That’s because 1) the RMD percentage is less than the expected real return rate on your portfolio for all those years; that means the real value of your IRA will increase. And 2) the RMD percentage increases each year: by age 83 it’s about 70% greater than at age 70½ (6.13% vs. 3.65%). That large increase in RMD may mean a significant portion of income from his Traditional IRA is taxed at a high marginal rate: the jump from the current 24% marginal rate to the 32% rate is the biggest enemy.

Conclusion: You always want to invest as much as you can for retirement into your IRA. The fundamental benefit of an IRA is that you AVOID paying capital gains taxes on the growth of your portfolio for many years. I calculate that the 20-year benefit is about 15% more for you to spend by investing in your IRA as compared to the alternative of leaving it in your taxable account.

You also play the game of different marginal tax rates when you contribute to your IRA and when you withdraw from your IRA. You’d pick Roth IRA or Traditional IRA in this game. In some cases the decision as to which is best is clear. Many times it is not. The benefit of this game is secondary to the benefit of avoiding capital gains taxes.

Like most all of us, I look often to see how the market and my holdings are doing. (Patti has it right: she never looks!) My looks are quick: is the market up or down today? Are my holdings up or down today? I know US stocks are generally up 10% or so in 2019, but I don’t calculate how we are doing overall very often. This week I calculated our six-month return ending May 31. May 31 is our six-month mark, because I use the 12-month results ending November 30 to calculate our annual Safe Spending Amount (SSA) for the upcoming calendar year. This post shows my calculations, states what I think our return implies for the end of the year calculation, and describes my view of needed actions now. That’s easy to summarize: NONE!

== Six-month Results: 1.8% ==

Our Investment Portfolio is up 1.8% at the six-month mark. As I describe here, I get the percentage return for each security I own using returns published by Morningstar: I only have four securities to worry about, so the calculation of the return on our total portfolio is very simple.

Results for YTD 2019 year are good, but I almost forget that stocks nose-dived in December. Bonds did not. As described in this post, that’s what bonds are supposed to do: when stocks crater, they don’t. We see a one-month snapshot of the insurance value of bonds at work. I won’t withdraw for spending for 2020 until early December this year, so this one-month view of bonds doing their job doesn’t mean anything. When I reach the 12-month mark on November 30 and sell securities for our spending in 2020, I may or may not see that same insurance effect at work over the whole year.

== What does that 1.8% imply? ==

Inflation is running about 2% per year – 1% over the last six months – so my real return over the last six months is about .8%. That’s a rate that is lower than my expected real annual return of 6.4% for our portfolio. Roughly 1% real return is not great, but it’s not horrible.

The roughly 1% real return tells me that Patti and I on track for the same Safe Spending Amount (SSA) in 2020 as in 2019. We are not on track to calculate a real increase in safe spending. I’d simply adjust our current $55,500 SSA for inflation. That’s okay because that’s a 20% real increase in spending power from the start of our plan – $44,000 spending in 2015. Here’s the summary of our calculation of annual SSAs so far. You’ll find the full explanation of the calculation in Chapter 9, Nest Egg Care, and the discussion of last December’s calculation here.

We may also be on the track for no real increase in spending for 2021. Nesteggers recalculate to a greater, real SSA when – basically – the real return on our Investment Portfolio exceeds our withdrawal rate. for example, we took out 4.6% for spending in 2017 and earned 17% real return in the year: that told me we’d have a big, real increase in our Safe Spending Amount for 2018.

Patti and I earned about -1% real return in the 12-months ending last November 30, 2018. We may be better but not my much this year. Let’s assume we earn less than 4% total real return for the two years. Our withdrawals will total about 9.5% for the two calendar years 2019 and 2020. That means we will have some catch up to do from greater returns for 2020 if we are to calculate a real increase for 2021.

== What adjustments should I make? ==

None. I have no reason to change our plan: spending rate, investing cost (already rock bottom; I really can’t get much lower), or mix of stocks vs. bonds. Our last real increase, calculated at the end of 2017, set us on a path of zero chance of depleting our portfolio through 2033.

The plot of the chance of depleting our portfolio looks like a hockey stick: many years of zero chance of depleting, an inflection point, and an increasing chance of depleting in the years thereafter. We locked that inflection point with our three key plan decisions. That shaft length through 2033 is to Patti’s age 86 and my 89; I can calculate that it’s 15% probable that we’ll both be alive then.

Conclusion: Every now and then we need to take a snapshot of how our portfolio is performing in the year. Unless you use December 31 as the ending date of your calculation year, the return that you want to track is a combination of one or two months of the prior year and the return year-to-date.

The six-month return for Patti and me, ending May 31, is 1.8%. That’s not horrible, but it is tracking to a return that leads me to think I won’t be able recalculate to a greater real Safe Spending Amount (SSA) for 2020. It looks like our SSA will be the same amount in 2019; we will simply adjust the current value for inflation. Our spending amount will still be 20% greater in real spending power than in the first year of our plan.

If you’re a diehard nest egger you only invest in Index funds. But some just can’t avoid the lure of trying to beat the market. Or just can’t make the switch to Index funds all at once. If you are hooked on trying to beat the market, this post recommends you open a new, tax deferred account for your Actively managed funds, ETFs or stocks and bonds. Put a small portion of your portfolio in the account. That allows you to continue to play the game of beating the market at a much more constrained level. You can clearly measure how good you really are.

== Nest Eggers and Index funds ==

Four Index funds do it for Patti and me. There’s no need to get more complex than that. The evidence tells me that over time Patti and I will be better than the 94^thpercentile of investors in Actively Managed funds. We’ll beat 100% of those who pay a financial advisor on top of fund fees. That’s good enough!

== Actively Managed funds aren’t good for us ==

Actively Managed funds damage the integrity of our financial retirement plan. Our plan looks like a hockey stick and a pile of money. We’ve made the three key decisions that have LOCKED in 1) the number of years of zero probability of depleting our portfolio in the face of the Most Horrible sequence of stock and bond returns in history – the shaft of the hockey stick – and 2) the amount of money that we would have over time if returns aren’t Most Horrible.

Actively Managed funds distort the shaft of our hockey stick. We don’t know from one year to the next how they will perform relative to market returns. We’ve lost our ability to predict shaft length. That means we can’t find and trust our Safe Spending Rate (SSR%) and Safe Spending Amount (SSA). About the last thing you want to do is add more unpredictability on top of future market results.

Actively Managed funds shrink the pile of money. Their Investing Cost on average is at least four times the default cost assumed by my favorite Retirement Withdrawal Calculator (RWC). Plug in the average cost of Actively Managed funds as an input to the RWC and you can see the pile of money shrink. Big time. (See Chapter 6, NEC.)

== The lure of trying to beat the market ==

The evidence tells us we win the game, beating at least 94 percent of all investors by sticking with Index funds. Yet it’s not easy to accept Index funds. With few exceptions, the financial industry is geared to telling you that you can beat the market. And our brains fight the decision to only invest in Index funds. I describe this problem here. We’ve view ourselves as smart, competitive and successful. Even though the evidence is that we’ll be better than the 94^thpercentile of investors, we just can’t accept returns that are a tiny bit less than general market returns. That just doesn’t feel right to some folks. They can’t resist the lure to try to beat the market.

== A “Sandbox” account ==

If you’re lured, I suggest you open an account in your tax deferred, retirement accounts and label it “Sandbox.” (It would take me less than five minutes to open a new account in my Retirement Accounts at Fidelity and then nickname it as “Tom’s Sandbox.” That’s what I’d see every time I logged in and looked at my Portfolio Page. I would also similarly be labeling Patti’s display of my account correctly.)

Then sell securities from another similar retirement account – you have no tax consequences for these sales – and transfer the money into the Sandbox. Make this your playpen for your experiments with Actively Managed funds, special-focus ETFs, or your choice of hot stocks if that is your cup of tea. Over time you will see how well your Sandbox account performs relative to your (in my case) “Tom’s Index Stocks” or “Tom’s Index Bonds”.

The only caveat I would recommend is to start out with a small portion of your total portfolio in your Sandbox. I’d suggest no more than 5% of your total. You may be lucky enough to be in the category of Happy Campers described in NEC, Chapter 5 with More Than Enough for their spending desires. Use some of your More Than Enough in this account. (You may have better choices as to what to do with your More Than Enough, though.)

Conclusion. We retirees should only invest in Index funds. The evidence tells us that those of us who do will be better than the 94^th percentile of all investors who don’t follow that advice. We have a financial retirement plan we can count on: we’ll know our calculated Safe Spending Amount (SSA) is indeed safe. But there is a powerful lure to do better. If you cannot resist, I suggest you open an account in your Retirement Accounts that is a Sandbox for you to play in. Keep the sandbox small and measure its performance over time against you much larger holdings of Index funds for stocks and bonds.

We all pay costs to invest. The amount we pay each year – our Investing Cost – lowers the amount we get to keep from the gross returns the market, in aggregate, provides all investors. Patti and I pay a predictable, small amount and our cost declined in February. This post examines how much less we will pay and how much more will be in our pockets. Answer: our Investing Cost dropped by 12% but that translates to just $50 per year per $1 million portfolio. A dollar a week. Small, but we’ll take it! (See Nest Egg Care (NEC), Chapter 6 for more discussion on Investing Costs.)

== Cost reduction last August ==

Last August our Investing Cost declined by 30% from about 7% of 1% of our portfolio value to about 5% of 1%. That was driven by Fidelity’s lower cost for the US Total Stocks fund that we own: FSKAX. It’s cost is 1.5% of 1%; that’s really low.*

== Cost reduction this February ==

Vanguard lowered their cost on a number of funds and ETFs by about 20% in February. This included two that we own. This translated to about a 12% total cost reduction for us.

What do we pay now? What fewer dollars do we pay? What more do we get to keep? There are a lot of decimal points to fight through for this calculation. I have to fight through calculations like this time and time again, because I don’t have the dollar amount we pay anchored in my head yet.

• I will be simplest for me if I state our Investing Costs in terms of $ per year per $1 million total portfolio. I can quickly go from that to the rough total we pay for our total portfolio. My friend Steve uses ¢ per $1,000 portfolio for his calculation; my brain does work easily with that starting point.

• It’s simplest for me to start understanding 1% of 1%. We now pay about 4% of 1%. I just have to plant 1% of 1% of $1 million in my head and then multiply by four. 1% of 1% of $1 million is $100. We pay about about $400 per year per $1 million.

How much did we save. I’ll get a headache if I start with that .0056%. Easier for me: we used to pay about $470 and now pay about $420. We pay $50 less per year per $1 million invested. $1 per week. Peanuts, but we’ll take it!

== A different look at the $50 ==

Here’s another way of looking at this: your financial retirement plan looks like a Hockey Stick and a Pile of Money. The shaft length of the stick is the number of years you’ve picked for zero probability of depleting your portfolio; that’s based on the assumption of the Most Horrible sequence of stock and bond returns in history. The Pile of Money is the amount you would have if the sequence of returns you face is not Most Horrible.

Lower Investing Cost always lengthens the shaft length of our hockey stick and always increases the Pile of Money. But $50 per year per $1 million portfolio has a very small effect on shaft length – you can count the lengthening effect in terms of days – and on the Pile of Money.

== Planting $400 in my head ==

I think I’ve done this calculation enough times that I should have the roughly $400 we pay planted in my head. But I don’t. Drawing this image is going to help with that. Go ahead. Draw one a picture like this if you have a hard time remembering your Investing Cost.

image

== What do these lower costs mean to you? ==

I bet that few retirees calculate their Investing Cost – fighting through the percentages is not easy – and then translate the percentage they pay into dollars. The financial industry just loves this: customers are in the dark as to what they pay! – even though they’ve been given the numbers to be able to figure it out. (See Chapter 6 and Appendix F in NEC and the spreadsheet in Resources on the home page to help with your calculation.)

I have friends who are paying $20,000 (2%) per year on this same basis and would have no idea that someone could pay $400. I think: “What an ugly looking hockey stick. What a puny Pile of Money. Patti and I are having a lot more fun with $19,600 per year than they are.”

Conclusion. If you are invested in Vanguard funds or ETFs, you are now paying lower Investing Cost than at the start of the year. The reduction was about 20% per fund/ETF. The weighted cost reduction for our total portfolio was about 12%. We were already low in total Investing Cost: we were paying roughly $450 per year per $1 million portfolio. The 12% reduction is about $50 per year less. We get $1 more per week! But we did no work for this. We’ll take it.

* Fidelity introduced two total market funds for their customers that have 0% Expense Ratio: FZROX and FZILX. I mentioned them here. I’m watching their net performance – net return – for investors to see if I should switch into them. Their construction – number of securities they hold, for example – do not match other total market funds, such as FSKAX or FTIHX at Fidelity or VTSAX or VTIAX at Vanguard. Other fund families have similar offerings.

I now have made two monthly payments that are, in effect, rent on our new furnace installed right at the end of last December. As I mentioned in this post, I decided not to use our financial assets to invest into non-financial assets. This post re-examines: was this the correct decision? Would you decide to rent your furnace or other capital expenditures to maintain your home? I think renting makes more sense the older Patti and I get.

I am renting in effect, because I paid for the furnace with our Home Equity Line of Credit (HELOC). We pay interest only, and I don’t ever plan on paying back the $8,000. Our monthly interest is now $36 per month.

== Years to build two kinds of Assets ==

We all have two kinds of assets: financial and non-financial. We retirees spent decades in the Save and Invest phase of life. Patti and I saved and built both financial and non-financial assets – the equity in our home; we don’t have other non-financial assets. (I don’t add in cars and furnishings in our statement of assets.) We didn’t plan on how much we should invest in financial assets vs. non-financial assets. Those investments just happened.

• In our 20s and 30s. We were renters until our early 30s, so any that we saved was invested in financial assets. We both saved and invested in our taxable investment account, but we worked to get as much as we could into tax-advantaged retirement accounts starting in our early to mid 30s. That’s when IRAs and employer defined contribution retirement plans were options for us.

• In our 30s, 40s, and 50s. We spent a significant amount building our biggest non-financial asset – our home. We made the down payment on our first home when I was in my mid 30s, and then we continued to invest in our home over decades when we paid our mortgage each month. Each payment decreased the principal balance of our loan and consequently increased our equity in our home. We invested when we improved our home with two air-conditioning units and duct work. (Our house was first built in 1918; for decades summers weren’t that hot here.) I’m sure we redid the kitchen twice. We added a large back deck.

• In our 60s. We sharply lowered financial assets because of a big shift to non-financial. We poured financial assets into the purchase and renovation needed for our current home, the one we will live in for the rest of our lives. We put in much more than the net proceeds from the sale of our prior house into this one and the new mortgage on this home.

== Building is over ==

• In our late 60s and 70s and beyond. We don’t have the outside income for Save and Invest. That phase of life is over. Now it’s Spend and Invest. The game now is to be able to safely spend (and gift) as much as is safely possible: our annual Safe Spending Amount (SSA).

In Nest Egg Care (NEC), Chapter 1 I based our retirement plan only on our financial assets and recommended you do the same. I considered our non-financial assets as a deep, deep Reserve. At the start of our plan, I thought the mix between our financial and non-financial assets was about right.

== Why add to non-financial assets now? ==

Time is not on our side. This December will be five years from the start of our plan. I use a Probability of Living Calculator and find that the expected number of years that Patti and I would both be alive will be just over eight years: 50-50 chance that we will both be alive nine summers from now! We need to FOCUS on what we both Enjoy Now. Shifting financial assets into non-financial assets doesn’t fit with that.

We’re putting stress on financial assets every time we put money into a non-financial asset. Every time we sell securities to withdraw our SSA for the upcoming years we are stressing our financial nest egg. Patti and I started our plan at 4.4% Safe Spending Rate (SSR%). Now we’re at 4.75%. When we’re in our early 80s, the SSR% that we could use will be more than the expected 6.4% real return on our portfolio (See Appendix D, NEC) . That math means our portfolio will likely decline, and that’s fine. Our life expectancies will be short – too short – then.

It’s unfair because our non-financial assets sees no stress. I find I’m continually taking money from our financial assets to spend on our home. Our home just loves this. It sits there and says to itself, “This is terrific. I’m getting a free ride here. When I need money, good old financial assets will pay 100% of what I need to keep me in style. Too bad if Patti and Tom have less to enjoy. That’s just the way it goes.”

That’s not right! Non-financial assets should carry more of their own weight – feel a little stress and not just pass it off to financial assets. Our home – our big non-financial asset – needs to cough up some cash to keep it in comfortable style.

I don’t know what’s fair to ask of our non-financial asset, but I think it should at least pay the capital costs to maintain its health or operating capacity. I’ve worked with non-profits who don’t exactly get the concept that a business has to earn enough profit (or surplus in the language of non-profits) to at least provide enough cash for capital equipment to maintain its competitive capacity. This is the same thing: non-financial needs to provide enough cash to carry it’s own weight. Here are some things that I think our non-financial asset – our home – should pay.

== The $8,000 Furnace ==

I want our home to cough up that $8,000. This conversation should not remotely come to our mind: “Oops. $8,000. We weren’t expecting to pay that. That’s a lot. Does this mean we can’t take that vacation we had planned?” That’s EXACTLY the wrong thought to have at this stage of life.

I obtained a Home Equity Line of Credit (HELOC) in 2012. The largest credit amount they would give me. It just sat there for years at a $0 loan balance. The only way Non-financial Asset can cough up cash was to have it borrow the $8,000 and transfer that to Financial Assets. That’s what I made it do.

== Am I harming heirs by this action? ==

Many retirees will think of this as lowering the ultimate value of their estate that would pass on to their heirs. I don’t think about it that way at all.

1. Our home is not going to appreciate in real value over time. Inflation distorts our understanding of this; it will be worth more paper dollars but not worth more in real terms. Our home and the money we add to the equity value of our home is going to keep its current real value over time, which means it’s going to earn 0% real return over time.

2. Compare that to the expected approximate 7% real return from financial assets. If I really thought I was harming heirs, I’d still have Non-financial Asset cough up the $8,000, decide to forego the vacation, and gift the $8,000 to our heirs. My favorite gifts are to 529 plans, their retirement accounts, and their HSA account, if applicable. All three have terrific tax benefits. I think of the Rule of 72 and think that $8,000 could be $32,000 in today’s spending power in 20 years – $64,000 in 30 years.

== Is the $36/month rent payment significant? ==

Nope. It gets lost in the other debits that hit our checking account or credit card statement. The monthly sum of these will vary by more than $36.

Conclusion: At some age – clearly the 70s for us – it makes NO sense to convert financial assets into non-financial assets. Enough with that! I drew the line this year when I made our non-financial asset – our home – cough up $8,000 that it needed for a replacement furnace. I didn’t pay for the $8,000 out of our annual Safe Spending Amount (SSA). Our Non-financial Asset borrowed the $8,000 and transferred it to our Financial Assets. This makes perfect sense to me: the $36 I have to pay each month, effectively as rent for our furnace, gets lost in the noise of other routine charges to our checking account or credit card.

The last post said you will be a successful investor – almost certainly better than the 94^th percentile of investors over time – by investing solely in Index funds. But very few individual investors do this. This post examines why they don’t simply stick with Index funds. Basic answer: our brains are wired to make bad investing decisions.

Here’s a longer answer: folks pay high, totally unnecessary fees for three main reasons.

1. Our brains are inoculated against the evidence that simple, low cost Index funds are clearly the path to investment success. Our brains form incorrect beliefs about investing and damn the evidence that tells us those beliefs are incorrect.

2. It also takes effort – using the thinking, computational part of our brain – to understand the evidence. Worse, no one makes it easier for us to understand the evidence – what we are paying each year on our investment portfolio is an example. It takes too much work to find and process the evidence.

3. We are driven to act to control an uncertain future. We know market returns will vary. The evidence is that we retirees should set our portfolio of stocks and bonds with just a very few mutual funds or ETFs (I have four that own almost all the securities in the world.) and stick with that for the rest of our life. Our brains think that is not enough. We feel much better with a portfolio that appears more complex and sophisticated, and then we want to fiddle with it to reinforce a sense of control.

As a result, our brains are willing to pay high costs for Actively Managed funds + Financial advisors despite the evidence that it makes NO SENSE.

(I credit this book and this book for helping me understand why our brains don’t follow evidence. This is also discussed, but less clearly, here.)

== The quick logic and evidence ==

Actively Managed and Index funds must have the same returns in aggregate before consideration of Investing Costs: that’s a mathematical certainty. The difference then is that Actively Manage funds will return, in aggregate, less to their investors by the amount of greater costs they charge investors. The cost difference now is about .8% per year. (This cost difference was greater in the past, and over the last 15 years the average Actively Managed fund underperformed by 1.2% per year.)

While some Actively Managed funds in some years can overcome their cost disadvantage, we investors have no reason to base our financial plan assuming that we or anyone else can pick the funds that will outperform. We retirees, in particular, need to build a financial retirement plan based on accepting market returns (at some small cost) and not on the assumption we can beat returns.

Since stocks return about 7% real return on average that .8% difference compounds to a LOT less from Actively Managed funds than from Index funds: $10,000s if not $100,000s over time. Those who pay an advisor, say an added 1%, are really throwing money in a hole.

== Here’s my imagined internal dialog ==

1. Our human brains tell us we’re smart and above average. “I’m above average. I perform better than average in everything I’ve set my mind to. Heck, that’s why I have a nest egg now and most folks don’t. NO WAY can I settle for just targeting to just earn the average that stock and bond returns give to all investors. If I invest in Index Funds I’m guaranteed to NEVER EVER beat the market. That concept is for those average folks. NOT ME. I can do better than that.

2. Our brains tell us we can figure out what to do to control an uncertain future. “This investing game is uncertain and really important now that I’m retired. I DON’T WANT TO RUN OUT OF MONEY. Something this important requires me to figure out a solution or to hire someone who is really good at this. It just CANNOT be as simple as investing in just a few Index funds – even if they hold pieces of all the stocks and bonds in the world. That leaves me at the mercy of market ups and downs: that’s just not right! I can control the ups and downs by my investing strategy. I can smooth out annual variability for both stocks and for bonds. I need to hold a lot of mutual funds. Every year or so I need to add good funds and drop the laggards. I need to increase and decrease my investment in individual funds based on their performance. It’s complex, but I can control this tiger!

3. Our brains assign skill to those we judge to be above average. “It’s complex to figure out how to be above average in this investing game. I need help. Maybe I can develop my own method to sort out the best funds or stocks. I’ll subscribe to services that provide recommendations or provide a lot of performance data that I can sift through. I even think this is fun to do.

“Maybe I just don’t have the time for that. My skill is that I can pick out other people who are above-average performers. That confident, friendly financial advisor I’ve chosen exudes Above Average. I can tell he’s (she’s) smart. Really smart. I can tell he’s a hard worker. The company’s offices looked great to me: quality folks all around. Those monthly reports I get are full of detail. I have quite a long list of funds that I own, and I’ve never heard of many of these mutual fund companies. My guy has really researched and picked the best funds from boutique firms for me. I feel that I’m in an exclusive club. It’s amazing that my advisor is able to follow all this. He must be spending a lot of time looking out for me.”

4. Once we’ve made a decision and formed a belief, we can’t easily step back to question that decision. “I trust that I or my guy can pick winning mutual funds even though my guy didn’t really tell me he could beat the market. Now that I’ve made the decision to buy a fund or pick my guy, I know that was the correct decision. I’m sticking with these decisions. To change is to admit that I made a mistake – paying far too much over the years – and I didn’t make a mistake. Besides that, a discussion with my financial advisor about not using him in the future is too uncomfortable for me.”

5. We don’t engage the computational part of our brain to figure out what we pay. “I have no clear idea of what I’m paying the financial industry – fund plus advisor fees – in total. I can’t find a summary of what I pay on the statements I receive from my broker: I don’t see the Expense Ratio that I pay for each fund I own; I don’t find the addition of all costs I pay in a year. My financial advisor said his fees were competitive, so I think I’m getting a good deal since I know he’s better than others I’ve met.”

6. We don’t engage the computational part of our brain to see how well we are doing relative to a benchmark using Index funds. “I can tell I’m doing just fine. The market was up in 2017 by quite a bit and my portfolio also was up by quite a bit. I was down in calendar 2018, but so was just about everyone. I’m doing great so far this year. I’m not bothered that my brokerage statement does not show how I do for my mix of stocks vs. bonds and my weights of US vs. International relative to a similar portfolio that uses those average-performing Index funds. Heck, I can’t really find my mix of stocks vs. bonds and US vs. International on my brokerage statement.”

Conclusion. To make the correct decisions for our retirement financial plan, we should realize that our default process is to make decisions based on intuition and emotion. We don’t use evidence and the computational part of our brain to guide our decisions. We have a drive to act to control the future that leads us to complexity and cost in our financial retirement plan. Understand these three tendencies, I think it is easier to dig for evidence and use evidence to guide your decisions and beliefs. The evidence says to ONLY invest in Index funds for your retirement financial plan.

I would think most retirees would be ecstatic if they knew they could be in the top 6% of all investors, and they can. But an amazing percentage of investors make decisions – or fail to make decisions – that would put them at the 94^th percentile of investors. You will have $10,000s more – perhaps $100,000s more – from Index funds relative to the average Actively Managed fund. This posts restates the evidence that you can decide to be in the top 6% of investors: stick with index funds.

The post is an update to my post of about ten months ago. I summarize the information from the latest SPIVA® U.S. Scorecard for the period ending December 31, 2018. SPIVA is a report of S&P Dow Jones Indices, Inc. S&P Dow Jones produces and sells measures of stock and bond performance (indices) to investment firms who want to use them as benchmarks of performance. It publishes the Dow Jones Industrial Average® and the S&P 500® index and many more.

SPIVA is the abbreviation of S&P Indices Versus Actively managed mutual funds. It compares how well Actively Managed funds perform relative to their benchmark index. SPIVA is a very thorough and objective 37-page report. Comparing performance can get tricky since poorly performing funds disappear over time (close or merge with others) and the methodology in this report accounts for the performance of non-survivors over time.

Morningstar displays the rank and performance of a fund relative to others in its category or style. But I don’t think Morningstar is accounting for the funds that no longer exist. You see this in Morningstar’s count of a much smaller set of funds in a category or style, say, 10 years ago as compared to now. When you only include today’s survivor funds in the comparison for performance over the last 10 years, you have tilted the population of funds to the surviving, more successful Active funds. That means for longer time periods Morningstar will rank an Index fund lower and rank a current, surviving Active fund higher relative to the SPIVA methodology.

== The Conclusions ==

The resulting data in this SPIVA report is almost exactly the same as in the prior report. The conclusions are the same. Bottom line: you can decide to be in the top 6% of all investors. You eventually will be at the 94^thpercentile if you invest in Index Funds. If you try to to be better than the 94^thpercentile, the probabilities are against you: you will wind up much worse.

1. Calendar 2018 was the ninth year in a row that a majority of actively managed funds failed to lag a broad index for the total market. In 2018 69% of actively managed funds failed to beat this index. This was the fourth worst performance since 2001.

2. Over a 15-year period, about 94% of all Actively Managed funds failed to outperform their peer benchmark index. That’s the same percentage from the report of 18 months ago. I’m still surprised that nearly 80% of all Actively Managed funds underperform their benchmark in just three years. What a bad track record!

3. On average, Actively Managed funds return about 1.2 percentage points less per year than their peer benchmark index. That’s the same deficit as in the last report. Using historical returns in this latest report, in 15 years you will have about $50,000 more from Index funds relative to each starting $100,000. You will have a lot more money if you stick with index funds.

4. Even an Actively Managed fund that performed well did not beat its peer index. An Actively Managed fund at the 75^th percentile over 15 years (the breakpoint to be in top 25% of all funds) underperformed its benchmark index by about .5 percentage points per year. (I don’t show the data for this. Trust me. It’s true.)

5. The poor performance of Actively Managed US stock funds holds true for International Stocks, US Bonds and International Bonds. The worst of these is US bonds: none(!) outperform their peer index over one or three year periods, for example.

== You’ll be better than Top 6% ==

The SPIVA report shows that a single Actively Managed fund has a 6% probability of beating its benchmark index (averaging over all funds for 15 years). A typical investor won’t just own one. Let’s assume a typical investors owns four of these funds. (It’s probably many more than this.) The probability that all four will beat their benchmark index is about .001%: hold just a few Active funds and the probability of outperforming a broad market index fades dramatically. Stated differently: if you hold a broad-based Index fund, you’ll almost certainly be Much Better than the 94th percentile of all investors.

Conclusion: The two SPIVA reports I’ve looked at over the last year give the same conclusions: you can be at the 94^thpercentile of investors over time by investing in Index Funds. (I argue you’ll rank much higher than this.) It’s folly to invest in Actively Managed funds: 94% fail to beat their peer index fund over a 15-year period; the average Actively Managed fund returned about 1.2 percentage points less per year. The cumulative effect is that Index funds return many $10,000s more – about 19% more. We retirees cannot afford to play our game with Actively Managed funds.

A Health Savings Account (HSA) is about the best investment opportunity ever: it’s Triple-Tax Free. Nothing beats that. You likely accumulate +25% more after-tax dollars for spending from an HSA than from the next best thing, your retirement accounts. This post explains why – if eligible – one should try to fully contribute to an HSA. And why, for us retirees – most all of us not eligible for an HSA – this rises to very high on the list of money-gifts you may want to make to your children or grandchildren.

I used to say that you could never avoid paying income tax on the money you spend. You typically pay income tax when you earn it, and then you pay capital gains tax on the growth. Then you can spend it – and often pay sales tax on that.

A retirement account is better: you pay tax one time – when you contribute or when you withdraw for spending, but the effect is the same for either a Roth IRA or Traditional IRA (and similar plans): you do not pay tax on the accumulated growth. The table above shows that the outcome for Roth and Traditional IRAs are the same. Read here if this is not clear to you – it’s not intuitively obvious that they are basically the same.

But a Health Savings Account (HSA) beats a retirement account: growth similarly is not taxed, but you pay NO TAX when you earn or when you withdraw for eligible spending. You accumulate more to spend with an HSA. (Read here on the 7% real return for stocks and here for the math for doublings that are mentioned in the note to the table above.)

== What’s an HSA? ==

A Health Savings Account (HSA) is associated with an eligible High Deductible Health insurance Plan (HDHP). Unfortunately we retirees who receive Medicare aren’t eligible. But your children or grandchildren may have an HDHP and therefore are eligible for an HSA.

HSA-eligible plans have lower monthly premiums but high deductibles shown below for 2019. The employee pays the first medical bills up to the stated deductible. Then the health plan pays most or all costs thereafter. An employee will know if the plan they pick is HSA eligible.

A high deductible plan is more attractive to younger folks who believe they are healthy and won’t consistently be out of pocket for the deductible. Since monthly premiums are lower, they’ll pay a lot less over time if they don’t spend much of the deductible. I think Patti and I went decades with very few medical bills. I think I visited a doctor less than once a year on average up to age 45. I would have found a high deductible plan attractive, but my employer never offered one.

Many employers only offer a high deductible plan (HDHP) that is HSA-eligible to their employees. I was on the board of Propel Schools, and that’s what they offered to their employees. Propel contributed to an employee’s HSA that they sponsored – that’s not unusual – such that the annual cost to an employee would always be attractive relative to a plan with a lower deductible – the kind I was most familiar with.

== Triple NOT TAXED #1 ==

Contributions to an employer’s HSA – or to one that an employee opens independently – are NOT TAXED. The employee records the contribution as a deduction from other income. An employee can contribute $3,500 in 2019 ($7,000 Family Coverage). Contributions are not limited by higher income. (Contributions to Roth IRA are limited by higher income; the tax deduction for a contribution to a Traditional IRA is limited by higher income.)

== Triple NOT TAXED #2 ==

Growth of an investment in an HSA is NOT TAXED. This is the same as for a retirement account.

== Triple NOT TAXED #3 ==

Spending on eligible expenses is NOT TAXED. I look over the list and find that Patti and I have a significant amount of these expenses now. We’ve both had big dental expenses over the past five years, for example. I really would like to have had a triple tax-free account accumulating for the potential costs of long-term care.

== Never worse than a Traditional IRA ==

Over age 65 you can spend from an HSA for non-medical expenses – that vacation to Hawaii! – and pay tax just as if it was withdrawn from a Traditional IRA. Unlike a Traditional IRA, you are not required to make annual taxable withdrawals after age 70½. On death, what’s left in the HSA is treated like an inherited IRA.

== The investment benefit ==

An HSA is always better than a retirement account when you spend for eligible expenses. The net after tax from a retirement account is always lower than the amount from an HSA by the marginal tax rate – either when you contribute (Roth IRA) or when you withdraw (Traditional IRA). At a 22% marginal rate, you’d have 22% less in an IRA; this equates to 28% more from an HSA. You can see the power of compounding of returns. Let the amount you put into an HSA compound for many years: you put in $5,000; you have $8,800 MORE in purchasing power in 30 years from an HSA than from, e.g., a Roth IRA.

== Zero Cost! ==

The landscape of independent HSAs (and maybe company sponsored HSAs) has changed. I remember high account fees and horrible investment options when I looked at HSAs years ago. A big change came when Fidelity entered the game of independent HSA accounts just last November. You can read an opinion on this plan. See here for more detail. Here’s my snapshot of what one gets with an HSA at Fidelity. You can’t beat this:

Conclusion. We older retirees aren’t eligible for a Health Savings Account (HSA). But your son, your daughter, or a grandchild now may have a High Deductible Health Plan (HDHP) that is HSA (Health Savings Account)-eligible. An HSA is the best investment account for the future: contributions, growth and withdrawals for eligible expenses are never taxed. Nothing beats this. We should urge our children and others in our family who have an HDHP to contribute. Your gift now to their HSA is about the best financial gift you can make. That’s a 28% better gift than eventually leaving the balance of your IRA to them.