Financial Policy Statement

Investment Allocation

The most important investment consideration is the asset allocation which will allow you to sleep at night. For example:

• 10% Cash
  • An investment class which will always return your dollar, but not much more. Usually loses to inflation.
• 15% Bonds/TIPS
  • An investment class which is expected to return more than cash, but is generally more stable than stocks.
• 50% Total US Stock
  • An investment class which provides reasonably high reward for reasonably high risk.
• 25% Total International Stock
  • An investment class which provides reasonably high reward for reasonably high risk.

Open an investment account at a reputable low-fee broker, choose a single low-cost index fund (either ETF or mutual fund investment types) for each of those four categories, then purchase the four chosen investments at the allocation percentage you have chosen.

Not sure where to start with selecting an asset allocation? Consider Larry Swedroe’s take:

• How much risk do you have the ability to take
• How much risk do you have the willingness to take
• How much risk do you need to take
• How to deal with conflicts between the need, ability and willingness to take risk

What does market risk look like?

• The US total market index dropped 56% from October 2007 to March 2009. It didn’t recover to the previous high until January 2013. Ignoring dividends, your investment return would have been zero for 6 years.
• The Nasdaq 100 index dropped 77% from March 2000 to September 2002. It didn’t return to the previous high until August 2016. Ignoring dividends, your return would have been zero for 16 years.
• The Nikkei 225 index dropped 62% from December 1989 to August 1992. It further dropped to the lowest level (81%) on March 2009. In June 2023 (31 years later) the index was 13% below the previous high mark. Ignoring dividends, it has not yet recovered to the previous high.

You want to avoid lump summing an entire life savings into a once in a lifetime market run-up (Japan). You want to avoid the increased risk of factor specific exposure (Nasdaq). You want a simple, diversified portfolio that can be rebalanced during inevitable drawdowns. It’s important to note that variance itself is not risk, rather it’s associated with underlying risk. In fact, rebalancing in a high variance scenario can lead to better outcomes than a low variance scenario.

Investments

Consider these low cost, high quality investments. Be extremely wary of any fund that is not on this list.

Account Types

A brief summary of account types:

And in slightly more detail:

1. Non tax-advantaged
   1. Personal brokerage account (AKA Taxable account)
      1. You open this account yourself at a reputable brokerage.
      2. You contribute to the account using money that has already been taxed (gifted or earned income).
      3. The growth (profit) is taxed at short-term capital gains or long-term capital gains rates any time you sell.
2. Tax-advantaged
   1. Personal
      1. IRA
         1. You open this account yourself at a reputable brokerage.
         2. You contribute to the account using earned income, and these contributions will be deducted from your federal income tax liability.
         3. The growth (profit) is tax free when held inside the account.
         4. You will be taxed ordinary income tax rates on the amount withdrawn from the account.
         5. Contributions are limited to $6,000/year (2022).
         6. You can’t withdraw money (penalty) before 59.5 years old.
         7. You must begin withdrawing a specified portion of the funds in your account at age 72 (year 2022).
      2. Roth IRA
         1. You open this account yourself at a reputable brokerage.
         2. You contribute to the account using earned income, and these contributions will not be deducted from your federal income tax liability.
         3. You won’t pay taxes on anything inside or withdrawn from the account.
         4. Contributions are limited to $6,000/year (2022).
         5. You can’t withdraw money (penalty) before 59.5 years old.
         6. No required minimum distribution while owner is alive.
   2. Employer
      1. 401k, 403b, 457b, and 401a
         1. Non-Roth
            1. Your employer implements and is responsible for this account.
            2. You contribute to the account using payroll deductions, and these deductions reduce your federal income tax liability.
            3. The growth (profit) is tax free when held inside the account.
            4. You will be taxed ordinary income tax rates on the amount withdrawn from the account.
            5. You can contribute up to $20,500/year (year 2022).
            6. Your employer may contribute additional money beyond the $20,500/year (year 2022) limit.
            7. You can’t withdraw money without penalty (excluding 457b) before 59.5 years old.
            8. You must begin withdrawing a specified portion of the funds in your account at age 72 (year 2022).
         2. Roth
            1. Your employer implements and is responsible for this account.
            2. You contribute to the account using payroll deductions, and these deductions won’t reduce your federal income tax liability.
            3. You won’t pay taxes on anything inside or withdrawn from the account.
            4. You can contribute up to $20,500/year (year 2022).
            5. Your employer may contribute additional money beyond the $20,500/year (year 2022) limit; however, this money is pre-tax (non-Roth).
            6. You can’t withdraw money without penalty (excluding 457b) before 59.5 years old.
            7. You must begin withdrawing a specified portion of the funds in your account at age 72 (year 2022).
   3. Self-employed
      1. One-participant 401k (Solo 401k)
         1. Non-Roth
            1. You open this account yourself at any reputable brokerage, as long as you are a single member sole proprietor/LLC.
            2. You contribute to the account using payroll deductions, and these deductions reduce your federal income tax liability.
            3. The growth (profit) is tax free when held inside the account.
            4. You will be taxed ordinary income tax rates on the amount withdrawn from the account.
            5. The employee (i.e. you) can contribute 100% of earned income, up to $20,500. This $20,500 limit (year 2022) is shared with W-2 income retirement accounts 401k and 403b.
            6. The employer (i.e. you) can contribute up to 25% of earned income, without going over the $61,000 limit (employer + employee contributions) (year 2022).
            7. You can’t withdraw money without penalty before 59.5 years old.
            8. You must begin withdrawing a specified portion of the funds in your account at age 72 (year 2022).
            9. You will need to file form 5500-EZ if you have $250,000 or more in the account or close the account.
         2. Roth
            1. You open this account yourself at any reputable brokerage, as long as you are a single member sole proprietor/LLC.
            2. You contribute to the account using payroll deductions, and these deductions won’t reduce your federal income tax liability.
            3. You won’t pay taxes on anything inside or withdrawn from the account.
            4. The employee (i.e. you) can contribute 100% of earned income, up to $20,500. This $20,500 limit (year 2022) is shared with W-2 income retirement accounts 401k and 403b.
            5. The employer (i.e. you) can contribute up to 25% of earned income, without going over the $61,000 limit (employer + employee contributions) (year 2022); however, this money is pre-tax (non-Roth).
            6. You can’t withdraw money (penalty) before 59.5 years old.
            7. You must begin withdrawing a specified portion of the funds in your account at age 72 (year 2022). This rule can be mitigated by executing a trustee-to-trustee rollover to a Roth IRA upon retirement.
            8. You will need to file form 5500-EZ if you have $250,000 or more in the account or close the account.
   4. Medical
      1. Health Savings Account (HSA)
         1. There is no Roth vs Non-Roth distinction.
         2. Only available if you have an HSA-qualified health plan, also known as a high-deductible health plan (HDHP)
         3. You open this account yourself at any reputable brokerage, or your employer implements and is responsible for this account.
         4. You contribute to the account using your own (gifted or taxed) money, or through employer payroll deductions. These contributions will reduce your federal income tax liability.
         5. The growth (profit) is tax free when held inside the account.
         6. You will not pay taxes on any money withdrawn from the account that is used to pay for qualified medical bills.
         7. You may contribute $3,650/year for an individual plan and $7,300/year for a family plan (year 2022).
         8. On death, a surviving spouse may inherit the HSA tax free. Non-spouse inheritance is immediately taxable at income tax rates.

Contribution Hierarchy

When you have spare cash what account should it be directed to first?

1. (Roth) 401k
2. (Roth) 457b
3. (Roth) 403b
4. Roth IRA
5. HSA
6. Taxable

As long as you are not at the top of the tax bracket now, and expect to be at the bottom of the tax bracket in retirement, any Roth option should be used as the default choice. Taxes are low right now, so there is little reason to defer to a potentially higher cost.

You can access your employers Form 5500 filing (annual return/report of employee benefit plan) at https://www.efast.dol.gov/portal/app/disseminatePublic.

What to do when you have a large tax deferred IRA and it’s preventing you from contributing to a Roth IRA? Roll it over to a one-participant 401k (solo 401k).

1. Get an EIN at https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
2. Earn money through self-employment, report it on schedule C and schedule SE.
3. Open a one-participant 401k.
   • The employee (i.e. you) can contribute 100% of earned income, up to $20,500. This $20,500 limit is shared with w-2 income retirement accounts 401k and 403b.
     • Earned income is defined as net earnings = total income - business expenses - 1/2 of self-employment tax .
   • The employer (i.e. you) can contribute up to 25% of earned income, without going over the $61,000 limit (employer + employee contributions).
   • Online calculators are available here:
     • https://sheet.zohopublic.com/sheet/published.do?rid=hd3vb2c79aa2e630443d58a05e8140934898a
     • https://obliviousinvestor.com/solo-401k-contribution-calculator/
     • https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/customer-service/401k-self-employed-owner-only-business.pdf
4. Roll the IRA over to the one-participant 401k.
5. Now contribute to the Roth IRA.

Replicating an index

Does your employer provide you with a mix of terrible or factor specific funds? While you’re waiting to recoup those losses after the class-action lawsuit, here is how you could replicate an index from a separate set of funds.

Schwab provides market cap distributions for funds.

• VTSAX (Target)
• VFIAX (Provided)
• VEXAX (Provided)

Let’s use OLS!

vtsax <- c(Giant = 41.6, Large = 30.9, Medium = 19.1, Small = 6.2, Micro = 2.2)
vfiax <- c(Giant = 49.1, Large = 35.2, Medium = 15.6, Small = 0.1, Micro = 0)
vexax <- c(Giant = 0, Large = 8, Medium = 38.1, Small = 40, Micro = 14)

mod <- lm(vtsax ~ vfiax + vexax)
summary(mod)

## 
## Call:
## lm(formula = vtsax ~ vfiax + vexax)
## 
## Residuals:
##    Giant    Large   Medium    Small    Micro 
##  0.06333 -0.10981  0.04869 -0.03637  0.03416 
## 
## Coefficients:
##             Estimate Std. Error t value  Pr(>|t|)
## (Intercept) 0.019539   0.144382   0.135  0.904742
## vfiax       0.845563   0.003354 252.135 0.0000157
## vexax       0.153307   0.004035  37.992  0.000692
## 
## Residual standard error: 0.1023 on 2 degrees of freedom
## Multiple R-squared:      1,	Adjusted R-squared:      1 
## F-statistic: 5.225e+04 on 2 and 2 DF,  p-value: 0.00001914

# Or, more simply
X <- cbind(vfiax, vexax)
Y <- vtsax
round(solve(t(X) %*% X) %*% t(X) %*% Y, digits = 2)

##       [,1]
## vfiax 0.85
## vexax 0.15

df <- data.frame(
  Size = factor(names(vtsax), levels = c("Giant", "Large", "Medium", "Small", "Micro")),
  vtsax,
  vfiax,
  vexax,
  replicated = round(predict(mod), 2)
)

df[c("vtsax", "replicated")]

##        vtsax replicated
## Giant   41.6      41.54
## Large   30.9      31.01
## Medium  19.1      19.05
## Small    6.2       6.24
## Micro    2.2       2.17

df <- gather(df, key = "Index", value = "Percent", vtsax, vfiax, vexax, replicated)

ggplot(df, aes(x = Size, y = Percent / 100, color = Index, group = Index)) + 
  geom_line(aes(linetype = Index), linewidth = 1.4) + 
  scale_y_continuous(labels = scales::percent) + 
  scale_linetype_manual(values=c("solid", "solid", "solid", "dashed")) + 
  scale_color_manual(values = c("#f8766d", "#00bfc4", "#c77cff", "#7cae00")) + 
  labs(y = "Percent of Index")

Investment Considerations

• Expense ratios should be below 0.25%. Be suspicious and avoid funds that are above this expense ratio.
• Utilize new contributions to rebalance the allocations.
• Rebalance quarterly/yearly/as necessary by adjusting the tax-deferred holdings or taxable holdings (if losses or long-term gains are available). A common rebalancing point is when allocations break the 5% absolute or 25% relative boundaries. The purpose of rebalancing is to buy one sector of investments that are down with a separate sector of investments that are up. This allows you to ‘buy low and sell high’ and controls the risk level you set in the investment allocation.
• Utilize cash and bonds as necessary to purchase on short term panic drops 10%+ or longer bear markets.

Tax Considerations

• Hold tax free bonds in taxable accounts. Or, even better, keep bonds only in retirement savings accounts.
• Tax efficient index funds (no capital gains) in taxable accounts makes life easier during tax time.
• A small number of invested index funds makes life easier during tax time (and general record keeping).
• Convert traditional holdings to Roth when marginal tax rate is low (<22%).