Sumit Mehta

As a Financial Advisor, Sumit uses his financial markets experience to help clients live their best lives. His core passion for helping others drives collaborative and consultative solutions to simplify the complex financial landscape many of us find ourselves in today. Sumit’s empathy and knowledge are integral to client confidence in financial decision-making. Sumit has [...]

Do you want to understand how to get the most amount of return for the amount of risk you’re willing to tolerate? Pure’s Financial Planner, Sumit Mehta, CFP®, AIF®, provides insight into what investing strategies can help you improve your odds of success and establish a foundation to achieve long-term goals.

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  • 00:00 – Intro
  • 00:35 – Getting Serious about Your Financial Future
  • 2:50 – Set Personal Financial Goals
  • 3:30 – Retirement Accounts: 4% Rule
  • 5:44 – Investing for the Future
  • 6:48 – Create a Budget
  • 8:53 – Investing Basics
  • 10:00 – Investment Choices: Cash alternatives, Bonds, Stocks, Asset Allocation
  • 25:13 – Q&A: How do you find your best ratio in terms of allocations? What’s best for you?
  • 27:56 – Portfolio Diversification
  • 29:24 – Mutual Funds
  • 31:42 – Exchange Traded Funds (ETFs)
  • 33:30 – Psychology of Investing
  • 35:38 – Psychological Investing Traps: Anchoring Trap, Irrational Exuberance, Over-confidence trap
  • 37:20 – Emotional Investing: Fear & Greed
  • 39:54 – Taxes & Investing
  • 43:54 – Tax Diversification
  • 48:12 – Q&A: What’s the best way to get money to a Roth? Is a Roth 401(k) better than a Roth IRA? Should I put everything in a Roth?

Note: At 51:42, all of Pure Financial’s advisors are experienced financial professionals. Pure’s financial planners generally are required to be CERTIFIED FINANCIAL PLANNER™ professionals (CFP®), Certified Public Accountants (CPA), Chartered Financial Analyst (CFA), or to have at least five years of financial planning experience. Within one year of hire, we require that financial planners attain the Accredited Investment Fiduciary (AIF®) credential to show a commitment to the fiduciary standard.

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Kathryn: Thank you so much for joining us for Investing 101 with Sumit Mehta, CFP® from Pure Financial Advisors.

Sumit: Well, thank you, Kathryn, and congratulations to everyone that is watching. I think that this is an important step to take to get educated as you get serious about your financial future. Educating yourself allows you to make educated decisions about your financial future. There are certain steps I would suggest you start with if you’re starting down the path of planning for your financial future. The first is to set goals for yourself. Understanding where you are, specifically what phase of life you’re in, allows you to manage goals differently because there are certain goals that are short term, others that are long term. Each of those requires a different type of planning. I want to highlight this one area, budgeting and tracking your current spending. It is a very difficult thing for most people to do, in my experience, to identify exactly what it is they’re spending and how much they’re spending every month to live.

There are folks I meet that underestimate how much they’re spending because we all have expenses that are automatically deducted from bank accounts. We all have expenses that we consider one time that crop up quite often, and as a result, we underestimate how much we’re spending. By having a budget and staying on track with your expenses, you are far more likely to be able to save toward the goals that I mentioned and again, establishing your goals is paramount to helping yourself prepare to reach them adequately. So saving towards the goals are important.

Saving in retirement accounts, especially if you have employer matching, is really important. There are some instances in which this is not as useful. I think that’s beyond the scope of today’s Investing 101 level seminar. However, I will point out why the importance of investing in retirement accounts cannot be overstated because of the balances we’re seeing across the country in people’s retirement accounts. We will talk about investments and how people invest, why people invest. I will emphasize that it is important to understand that risk and return go hand in hand. You cannot get a return without also taking commensurate risk. So it is important to balance the two; as the two do not exist without each other.

I mentioned goals and mentioned different phases of your life in which you may have goals that are different. Some of these goals are short term, some are long term. All I’ll say on this is that it’s important to understand what your goals are so that you can have a path laid out that helps you prepare for them. One of the factors I would recommend everyone think about and remember is that time is one of the most crucial components of determining investment return.

I’m going to introduce a concept called the rule of 72. I’ll talk about it in a minute. I would encourage everyone to write this down, look it up, do the math for yourself and understand why time is one of the most critical factors in helping determine overall investment return.

I mentioned retirement accounts and how they are woefully unfunded. This is the average retirement balance for people across the country. Now, why do I say it’s woefully unfunded?! Here’s another concept I would recommend you write down, and that is the 4% rule. Think about the fact that over the course of your life, you have three sources of income. You have earned income, which is what you get from your jobs. You have fixed income, which is what you get from social security and perhaps a pension, if you’re lucky enough to have one. Then you have investment income, which is what you get from your investments. This is effectively your money making money for you; when you’re no longer making money for yourself it really comes into play. As an example, if you’re looking to have $150,000 in retirement, and you are getting $50,000 from social security. That means you need $100,000 from your investments. What does the 4% rule state? The 4% rule simply states that if you are looking to have $100,000 from your investment accounts, that cannot represent more than 4% of the total. For those of you who find it as difficult as I do to divide by 4% there is a much easier way to do this. It’s simply to multiply by 25. In other words, multiplying 100,000 by 25 tells you how much money you need in order to have $100,000 a year in retirement. That’s $2.5 million. That’s $2.5 million saved up by the time you retire, if your lifestyle costs $150,000 and if Social Security is paying you $50,000 is what the 4% rule states. That $2.5 million is what you need to last you through 30 to 40 years of retirement. Having gone through this exercise, I would encourage each of you to go through it for yourselves. You may now see why these average account balances are woefully inadequate for the vast majority of Americans.

Investing for the future can be hard. We are not built and wired to invest as much as we’re built and wired to enjoy life as it approaches us every single day. We are living longer than we’ve ever lived. We’re retiring at the same age we’ve always retired, which means we need to finance a significant portion of our lives. That is far greater than our parents and grandparents ever had to. Add to that the absence of pensions for most people that are of working age today, and you’ve got a problem that continues to exacerbate for folks that are unprepared as they get into retirement.

There are some ways, and there’s a fair number of items on a list like this. I chose these three because I think they’re fairly simple and they’re easy to get started with. Building a budget, automating savings, and then focusing on saving a percentage of your income. These are three ways that you can help yourself prepare for your own future. I’m going to go into each one of these one by one.

Creating a budget is important in helping work within a budget. As I mentioned earlier, the vast majority of people don’t know how much they’re spending. The result of not knowing how much you’re spending means that you are also not able to control your savings. We all know what we make, and if we don’t know what we spend, it’s difficult to have a budget to save. That’s when the importance of a budget comes in. An example of a budget is right here. You may allocate a certain amount to items that are simply necessities, such as housing and food. You may allocate an amount of items that are nice to have, they’re discretionary spend items, such as dining out and vacations. And you may think about how much you need to have based on where you are in life and what your number is to get from where you are to where you’d like to be.  Again, it is difficult to over emphasize the importance of establishing your goals so that you can prepare to get there in a manner that is sustainable for yourself. I’d like to share with people if it’s not sustainable, it’s not sensible and it’s not scalable and you need all decisions you’re making to satisfy all three of those in order for them to stick.

Another way that you can get your plan to stick is simply to automate your savings. If it’s coming out of your paycheck, if it’s coming out of your bank account, you’re not thinking about it, you’re not spending it because you don’t have it. It is somewhere else. The same way that you might be contributing to a 401(k), the same way that your paycheck already has taxes taken out. If you also put a percentage aside for savings that is a very good way to not have to keep track of every dollar you’re spending because your savings component has already been taken care of.

Now, why do we invest? In my earlier example, I got to a number of $2.5 million, which may seem daunting for some. It may seem achievable for others. If there is a component of this audience that thinks, well, how am I going to get to $2.5 million? Well, you’re not going to get there by keeping money in cash. Having cash in a bank is a very safe and slow guaranteed death at the rate of inflation. Every year that goes by your cash is going to buy less and therefore you’re not paying yourself by having cash, you’re paying yourself by investing that money and investing it wisely.

Having an understanding of your goals, understanding that investment while you’re managing risk is one of the only ways to provide a potential for return are both crucial to establishing an investment plan.

What are some investments that you can think about and make? We all have several investment choices. There are three on the screen. I’m going to go over the fourth, which is a concept. It’s not an investment choice. It is something that is crucial in ensuring that you have, along with time, the right recipe for success as you set up the investments for the next phase of your life.

We’ll start with cash alternatives. What are cash alternatives? They could be high yield savings accounts. They could be bank CDs, and they could be money market deposits. They’re also money market mutual funds. Each of these has its own set of criteria associated with it. By criteria, I mean yield. How much are these instruments paying you to have your money in them? And taxation, how much is what you’re making being taxed, depending on what you’re in and where that instrument is sitting. You may have heard the old adage, It’s nice to know what you make. It’s far more important to understand what you keep. That’s where taxes come into play, and I would encourage you to explore what the after tax return is on any one of these instruments as you’re deciding which one and when and with how much you want to invest in one of these.

The next investment option on the list is a bond. A bond very simply is a company borrowing money or a government borrowing money from people like you and me. Why do companies do that? They may need to buy inventory. They may need to hire people. They may need to buy equipment. Governments need to build bridges, they need to build roads, and they issue bonds in order to have money to build these roads. Money is not free and therefore these companies and these governments have to pay out to bond holders a certain rate for the privilege of having their money. In the old days it was called a coupon rate. The only reason it was called a coupon rate is because the old bonds came in as a piece of paper with coupons attached and you had to peel out a coupon at a time to mail it in to get your interest. Of course, all that is automated now, it’s all digital. Bond rates are still called coupon rates, but they’re automatically deposited into the account in which you hold that bond. The interest rate on bonds can be varied depending on what the bonds are. Certain companies pay higher interest than others. Certain governments pay higher interest than others. The federal government, as an example, has a very high credit rating relative to perhaps a local government, and those rates may be different as a result. If you don’t really trust me to return your money. You might want a higher rate from me in order to be enticed to give it to me. I’ll talk in a second about how this comes into play when looking at the risk behind the bonds that you might be faced with choosing.

The other important component of bonds is taxation. Different bonds are taxed differently. If you buy a bond within the municipality in which you live and it’s a municipal bond you’re not taxed at all. I’ll emphasize again, what you make is important, what you keep is far more crucial. As you’re looking at bond yields, it is important to understand what your after tax yield is on every bond you are considering purchasing.

I mentioned the appeal of high rates. I have a number of folks I meet with consistently that come in telling me that they found this bond with an 8% or 9% yield and they’re excited to buy it and it is clearly better than an equivalent bond with a 5% yield. I like to remind them that if Nike or Apple wanted to borrow money, they would have no shortage of people running to give their money to those two companies. However, and I’m not going to use a name because I don’t want to pick on anyone, but if a company that perhaps most of us have not heard of wanted to borrow your money, you might look at them with a far more skeptical eye. Well, that company not having the same demand as Nike or Apple would have to pay out a much higher rate to attract your money because of the inherent risk behind whether or not that company could continue to survive.

As you’re thinking about bonds, specifically which bonds to invest in, where to invest in them, and how much to invest in them, understand that risk and return, again, go hand in hand. Just because a bond is paying you a higher interest rate, does not mean that it is equivalent, in fact, more often than not, it does mean that it is far more risky than a bond that’s paying you a lower interest rate. Which then begs and brings into question whether or not that bond has a place in your portfolio. If you have a portfolio that’s adequately diversified, i. e. has bonds and stocks and other instruments, then you want to look at the overall portfolio risk you’re subjecting yourself into rather than looking at the risk by instrument within that portfolio. Simply looking at bond risk is one decision to make. Understanding how it plays with all the other risks in your portfolio is a better and more important decision to make. I might suggest that bonds may not be the place you want to take risk because if you own stocks, they are replete with plenty of risk.

Not all stocks share the same risk depending on the size of the company, the length of time it has been in business and whether it’s in a startup phase or a more mature phase, you have a different chance of it staying in business and therefore a different level of risk you are taking when you decide to invest in the stock of that company. Stocks have a very binary risk outcome when it comes to the extremes, you do have the possibility of unlimited returns in a stock. You also have the possibility of if the company goes out of business and your investment goes to zero. I’ll emphasize again, it is really important to understand the risk behind every one of your investments and also the risk amongst all your investments and specifically how they play together.

There are two types of stocks. There are common stocks, which are traded on exchanges, they’re what most people own, and there are preferred stocks, which are slightly different from common stocks. They both entitled the owner of the stock to a piece of the underlying company that the stock represents. However, common shares typically come with voting rights and preferred shares do not. Also, preferred shares have priority. They stand in line ahead of common shareholders over the income of a company. They typically have creditors, which include debt holders. So bondholders are first in line, which makes bonds even safer. Preferred shareholders are next in line, and then common shareholders come last. So as you’re looking at and evaluating companies, understand where you are in the order of investment that will receive income as it’s available from the business.

One of the sentiments I hear very often is, now is not a good time to invest or now might be a better time to invest. Or have you seen the news? What’s going to happen to X, Y and Z, whether it’s social security or China or Russia? The list goes on. I think we can all generally agree that the news is mostly depressing and if it is good news, it’s no news, which is why you’ve got the, if it bleeds it leads mentality in almost all of the news we hear today. That emotion building news cycle does drive investment habits that are generally not rewarding. One of those habits is to try and time when you want to get out of the market or when you want to get into the market. Studies have shown that this simply does not work. If you’re trying to figure out when to get in and when to get out, I would suggest that is statistically an exercise in futility and that your brain power might be better served focused elsewhere, rather than trying to figure out if this is the right time, COVID hit, am I out? Did I also then come in 41 days later? Has the market doubled since then and did you expect that? There’s a lot of variables that make it nearly impossible to understand exactly when to get in and exactly when to get out. In fact, as you see on this chart, there are returns that are very tilted based on a very small number of days. If you were in the market or out of the market on those days, your end result is drastically different. In fact, when we look at data, the average person. underperforms the market by a very significant margin. But the opposite is fairly easy from a mathematical standpoint. If you buy the market, you stay in the market, you’re going to do what the market does. Yet the average person does not do that. Why is that? It’s because of psychology, and we’re going to touch on psychology in a few minutes. But one of the results of human psychology is thinking that people know when to get in, when to get out. I’m going to emphasize again, avoid trying to time the market.

The market is volatile. It goes up and down all the time. I have no idea what it’s going to do tomorrow, next week, next month, or next year. I do know that over time it goes up. So if you are adequately diversified, and if you’re patient, Over time, you’ll make money. If you think you can pick these bottoms to get in and these tops to get out, again studies have shown that does not work.

The other thing that doesn’t work is picking stocks. Now, what this chart shows is a study done by three gentlemen that won the Nobel Prize in 1986 called Brinson, Hood and Beebower. They determined what actually produces return over time. If you want to make money and make money consistently, what do you need to do? We talked about avoiding market timing that has a 1.8 % impact on overall return. What I might suggest is that picking stocks as shown by data, also has a very small percentage on overall return. I was around in the first dot com boom and I can remember very clearly the heyday stocks of 2000, GE and Cisco. If you were one of those people that were piled into those stocks, congratulations you’re down 30-50% 25 years later. When people ask me what I think about Meta or Tesla or Apple or any of these names, I have no idea. I don’t know what’s going to happen 25 years from now. Data shows and studies show that most people don’t, in fact, the average portfolio suffers and does not benefit when there’s an overemphasis on something that is so unimportant on a relative scale.

So what is important?

Asset allocation is the most important determinant of portfolio performance along with time, adequate diversification, and patience are the best ways to make money. What is asset allocation? It’s simply understanding how much to buy of stocks, bonds, other options, such as cash equivalents, and understanding within those asset classes, how much money to put in foreign stocks versus domestic stocks, for example. You can continue going down that decision tree. If you look at foreign stocks, well, how much do you put in developed markets versus emerging markets? If you look at emerging markets, well, how much do you put in India versus South Africa? Those are questions that you can continue to ask and answer. Sophisticated asset allocation models, with the help of a professional if you are able to stay patient in them and with them, are the most surefire way to have an adequate return over time in your portfolio and help you get to those goals that we talked about earlier. Such as having enough money to retire and retire without financial stress.

This is simply a representation of what an asset allocation model might look like. I would suggest that this is a very good start. However, it’s not a complete asset allocation model. You can continue to divide this pie into various components of stocks, such as U. S. large, medium, small, foreign, developed, emerging, like we just talked about. And bonds such as government bonds, corporate bonds, municipal bonds, et cetera. The more you’re able to dial in every component of this asset allocation decision, the more you’re able to dial in the overall risk and return profile of your portfolio. This is one of the most important decisions you can make when starting to invest money. I see Kathryn here. Kathryn, do we have a question?

Kathryn: I’ve been getting a lot of questions about how do you find your best ratio when you’re talking about the different allocations and the splitting up of the stocks? People are asking, “how do you figure out what’s best for you?”

Sumit: The way I would think about how to even approach that is to think about the cash flows you need over the course of your life. I’ll just use my earlier example of being retired and wanting $150,000, knowing that I have $50,000 coming in from social security.  I now need $100,000 out of a portfolio. I share the 4% rule and we came up with $2.5 million as the right portfolio, the right size of portfolio based on that rule to spit out $100, 000 a year or 4%. Which also implies that if that portfolio were designed to spit out 6.5-7% on average, then after taxes and accounting for inflation, you can keep 4% and spend it. That doesn’t touch the overall portfolio. That is the genesis and basis of the 4% rule.

How do you get 6.5-7%? There are very sophisticated models that are now in place that allow for someone to look at cash flows. Understand the required rate of return from their portfolio and back into an asset allocation that’s appropriate to achieve that required rate of return.

I’m going to say two things. They both mean the same thing. Important to think about both. The first is, you don’t ever want to take more risk than is necessary for the return you are trying to generate. And the second is you want to get the most amount of return for the amount of risk you are willing to tolerate.

In the old days, there were far less sophisticated ways of doing this, and people simply looked at 100 minus age as the number that should have been in bonds. The rest should have been in stocks, etc., but that’s not the way we do it anymore. We use sophisticated models. We run cash flow projections. We understand required rates of return. We have an immense amount of data and computing power that helps us get there. I trust that, at least begins to answer the question. It can get very detailed and I would encourage whoever asked this question. Great question, by the way, to take this offline and come talk to us. We’ll be happy to sit down and talk to you more about this.

Diversification is part of allocation. Why is it that we are putting money into not just stocks and bonds, but drilling far deeper into the kinds of stocks and the kinds of bonds that collectively constitute an optimal portfolio? Why do we do that? For those of you who are local and live in San Diego like we do, think about this past winter, and think about what would have happened if you had a business on the beach that simply sold suntan lotion. Given the amount of rain we had, you would not have had a lot of sales for much of the winter. It was important for you to diversify into umbrellas so you could make money rain or shine. That’s effectively how a portfolio works. Think of it as an eight cylinder engine. If you are adequately diversified; within that engine there are pistons that are going up and down at all times, but the engine is moving forward. While we have no idea and experts can try to predict, and they’ve been proven wrong, what the markets are going to do in any given month, week, or year. We do know how they act in concert with each other. And we do know how they act over time. Having a portfolio that is well diversified is one of the keys and components of asset allocation, which, along with patience, is the only way that studies have proven you can make money over time.

I want to talk about a couple of investment options that are sort of part of the investment universe, they’re packaged goods. They’re not single stocks. They’re not single bonds. They are instruments you can buy that have stocks and bonds as underlying holdings in order to highlight pros and cons of each, as you might be making decisions about which ones are appropriate for you and your objectives.

The first are mutual funds. Well, mutual funds are a vehicle that takes funds from a lot of different people and puts them together to mutually have a healthy amount of money with which to buy either stocks or bonds or cash equivalents. A vast majority of 401(k) plans have mutual funds in them, which is why a vast majority of U. S. households own mutual funds. I will say that over the past 20 years, there’s been a new instrument that has produced superior returns at lower costs than mutual funds. In terms of total assets, it has garnered more of a share than mutual funds have, even though a far greater majority of people own these funds inside of their 401(k) plans. I’ll get to that instrument in a second. A couple of comments on mutual funds. They are expensive. And the vast majority of fund managers because they tried to either time the market or pick stocks, (studies have shown, as we just talked about, is a failing strategy) also fail to beat their benchmark. anywhere from 85 to 90% of mutual funds are not performing up to their own standards, their own benchmarks, and you’re paying perhaps 5 to 6 times the price as you would for the other instrument I mentioned. It’s a puzzling thing to see that there’s a product with an 85% failure rate that’s five times more expensive and over half of Americans still own it. Word of caution on mutual funds – There are better alternatives to mutual funds for every one of us out there.

This is one of them. This is the instrument I was referring to. They’re exchange traded funds. These funds are not driven by a mutual fund manager’s whim as to which stocks to own, when to own them, when to buy and sell them. for the most part, there are exceptions to everything I’m saying. For the most part, these ETFs are a good way to buy an index to have index performance. Perhaps this makes it a little more clear if we’re just talking about the S&P 500 index. Those are the 500 largest companies in the U. S. They all perform collectively to produce index performance. An ETF that mimics S&P index performance is going to produce that return at all times. It’s automated. It owns a piece of all 500 of those companies and therefore collectively has the results that those 500 companies demonstrate. A mutual fund, by comparison, may have a fund manager that picks only 300 or 80 or 200, pick your number of those 500 companies in an attempt to do better than those 500 put together. Where you’re going to pay a lot for that person’s time and expertise, and more often than not, come away without even achieving that index performance. ETFs cost a fraction of what mutual funds cost with better performance. We lean toward ETFs in almost every instance, if there is an option to replicate an index versus a mutual fund.

I want to move on to this because it is an area that’s both a personal fascination, as well as something I’m seeing manifest itself into decisions people make over the course of their investment careers. At a very high level, human beings are built to survive and reproduce. We are not built to make long term strategic financial decisions. Also at a high level, human beings are built for action. We want to keep doing stuff. While the market rewards inaction.

The Brinson, Hood and Beebower study clearly showed that having an adequately diversified portfolio and being patient with it is the only way to make a healthy return consistently over time. What we’ve also learned through studies done by Terrence O’Dean, who was both my professor in graduate school as well as one of the fathers of the psychology of investing. He studied thousands of brokerage accounts and specifically trading data. He had a couple hundred thousand trades that he dissected and he found that the more people trade, the less they make over time. Humans are wired for action, and that’s why we like to buy and sell. We like to time the market. We think we can read the news and trade a stock. The market rewards inaction, and therefore, the psychology of investing becomes paramount in understanding. Not that we can control our emotions because we’re emotional beings, and we all experience emotions, but an understanding of how to identify those emotions so we can perhaps put into practice ways in which we can prevent those emotions from dictating our actions. Specifically those actions that end up hurting us from a financial perspective over time.

Let’s see how this plays out in some of the ways in which we think. Well, there’s an anchoring trap. The anchoring trap simply states that once you start believing something, if you are looking at views that support your belief, you become more convicted. If you look at views that challenge your belief, you simply disagree with them. You’ve anchored your belief on a certain point. And those of us that had anchored our belief that Cisco was going to take over the world in 2000. Well, we’re sitting here 25 years later, having lost a third of our money in that stock. That’s an example of how an anchoring belief can trap you by staying in an investment far longer than it has proven to be worthwhile.

Another trap is a sunk cost trap. I hear quite frequently from folks that they own a stock, it’s down from where they bought it. They are just waiting for it to come back to the price at which they bought it so they can sell it and move on. The market doesn’t care about what price you bought anything. The market’s not waiting for it to come back to your price for any reason whatsoever. The only way to make a decision about your money is to think about what the best use of your dollar is from today onwards. Look up some of the heuristics that dominate the human mindset and think about whether or not they apply to your life. How you might be making investment decisions because of them or in spite of them, and perhaps become more conscious and cognizant of what you might do to eliminate, and if not eliminate, certainly reduce the impact that these subconscious emotions may have in your investment decision making.

This is something that happens very commonly, and it’s a result of fear and greed, the most basic of human emotions. When the market goes up, we are happy. We become greedy. We pile in. In fact, quite commonly, the last leg of a bull market is the steepest because there’s mass FOMO and people want to get in before it’s too late.

The term irrational exuberance was introduced by Alan Greenspan in 1996. The dot com bubbled up and burst till after 2000. You had a very healthy and large increase in 1998 and 1999 in any company that simply changed its name to dot com. Because people were afraid of missing out on the dot com boom and they got greedy and ultimately, after march of 2000, the Nasdaq lost 78% in 14 months. Why did it do that? Why did it effectively take the stairs up and the elevator down? There was a rampant amount of fear of losing money, not fear of missing out. Now the fear was about losing money. The result of making investment decisions based on greed and fear is that people buy toward the top and sell toward the bottom. Which is the exact opposite of very sage advice given by none other than Warren Buffett, which is to buy low and sell high. When we act on our emotions, we do the opposite of what serves us. Understanding both those emotions and our tendencies to act on them is the first step to helping prevent what we are seeing in data. Which is that the vast majority of people don’t achieve what the market does when, in fact, it is a fairly easy thing to do once you understand it. I mean that as a comparison to most other professions where you’ve got to be a doctor to perform surgery, you’ve got to be a carpenter to know how to build certain things. You don’t have to have a lot of understanding to simply buy an index instrument and have the performance of an index beating 87%t of professionals out there. I can’t think of another profession in which that is achievable by the average person at home.

That’s what I wanted to share on the psychology aspect. If you’re interested, there’s a fascinating amount of data and research that you can dive into.

Getting back to our notion of, it’s nice to know what you make; it’s more important to understand what you keep. The difference is taxes and how you deal with taxes. Now, there’s a lot to talk about with taxes, and unfortunately, there aren’t a lot of people that are both well versed in the investment side of things as well as the tax side of things. Traditionally, if you wanted your taxes done, you found a CPA. If you wanted your investments managed, you found a broker or a financial advisor.

Well, over the last, several years, and in fact, there’s a lot more of this that I think needs to happen. Those two professions have come into a core where they are working together to help you make decisions. It’s difficult to make investment decisions without understanding the tax implications. Let’s look at how some of that has manifested itself in the course of where we all sit with our investment accounts.

In the old days, there were pensions and just a little bit of history, when the retirement age was deemed to be 65, the life expectancy was 64. You were fully expected to work till you died. No one owed you a pension as a result of that. Pensions were very rampant because the obligations companies were signing they could meet without a lot of financial backup. What’s happened in the years since. Retirement age is still 65 and life expectancy has now extended where we, I think, can all name someone we know that’s lived to their 90s. When you used to need money for perhaps a year or two, you now need money for perhaps three decades. The result of that was that pension plans gave way because companies simply couldn’t afford them. And while they still exist, they’re massively less popular than they used to be. Those gave way to saving for your own retirement.

When I grew up and I suspect a lot of you, and this still exists, are working at companies, the sage advice that we’re all given is, well, put money into your retirement plan. You’re not going to pay taxes on it. You’re going to need this for retirement. A 401(k) is a great way to park money, and you might even get an employer match to do it. I’m not suggesting that you don’t do that. I’m simply suggesting that there are consequences to doing that, that you’re aware of those consequences so that if those consequences apply to you, you can do something about them.

What am I talking about? These are the contribution limits for 401(k) plans. If you’re over 50, that limit rises to $30,000 because you have a catch up contribution. What does this mean? Recall the automated savings component. Given that this is taken out of your paycheck, it is the most common place for people to save money. If I put in as much as I can into my 401(k), I’m prepared for retirement. That’s the mentality with which most people save. The result of that is that this area, in this country, has over $30 trillion in assets currently sitting in it. What is the issue here; Why is that a problem? Isn’t that a good thing? We all have money in retirement. Yeah, for the most part it is. We’re talking about taxes. Let’s look at where this money sits.

Quite simply, there are three types of tax environments and accounts that sit within each one of these environments. There is a tax free environment. Which has Roth IRAs and municipal bonds that occupy this environment. As advertised, you don’t pay taxes on anything that comes out of this environment.

There is a taxable environment, which is your regular brokerage account at E Trade, Robinhood, you name it. And as long as you hold any instrument in this environment for a year and a day, you pay what are called long term capital gains taxes. Those range from zero to 20%. For most people, unless you’re in the lowest or highest tax bracket, they are 15%.

Finally, there is the tax deferred environment. This is where 40(k) plans sit. It is also where IRAs sit. And in fact, anything that starts with a 4, a 457B, a 403B, a 401A, all sit in this environment. Because you’ve never paid taxes on this money, and that was the incentive to put money in here in the first place, The IRS has not forgotten that, and they’re going to want their piece of these monies that are sitting here currently $30 trillion when that money comes out of this environment.

If your objective is to pay for your entire retirement with money that’s sitting in one of these accounts, know that as the money comes out, you are going to be paying ordinary income tax, which currently ranges from 10 to 37% on the federal side, and depending on where you live, you have to add on your state tax on top of that.

Well, here’s the issue that most people face in retirement, and I’ll go back to the example I started this talk with, which is the $150,000 you need, where $50,000 comes from Social Security, and $100,000 comes from your savings. If $50,000 comes from your social security, keep this in mind, social security also sits in this environment. It is taxed. If $150,000, in my example, is coming out of this environment, you are in a tax bracket that you may not want to be in, that you may find is higher than the tax bracket you were in while you were working. If you’re in the 22% or 24% tax bracket, and if you live in the state of California, you’ve got another 9.3% or 10.3% in taxes. A third of that money belongs to the government and having you think about your retirement nest egg at a million bucks versus thinking of it with a third gone may make a very large difference to that $2.5 million that you are trying to get to, to support the numbers in my example.

It becomes really important. And I trust this illustrates the point to look at the after tax amount of money and return you have versus looking at it without paying attention to the taxes associated with it. This is a very high level on the importance of taxes in investing. There are lots of strategies if you are in this position to help you address what might be a tax time bomb waiting to blow up. I would again encourage you to talk to a professional if you are in the shoes of someone who is looking at multiple accounts and trying to figure out how to make sense of all this and by the way, I also have a pension and that sits here as well. You can perhaps see how the problem continues to exacerbate.

I see Kathryn again. So I’ll pause to see if Kathryn has another question.

Kathryn: What’s the best way to get money into the Roth? And is a Roth 401(k) is better than a Roth IRA? And should I just put everything into the Roth, if I have money, and if all my savings is in my regular 401(k) or regular Roth?

Sumit: Several parts of the question, Kathryn, I hope to get to all of them. The first one was how to get money into a Roth IRA or 401(k). Well, there’s two ways to do it. One is to simply contribute and you can contribute $6.500 this year into a Roth account. Unless you are making too much money and there are tables published by the IRS, depending on how you’re filing, whether it’s single married or head of household as three examples on whether or not you can contribute into this account. Again, that’s $6,500 per person, $13,000 for a couple. If you are over 50, you’ve got a $1,000 catch up allowed per person gets you to $15,000 per couple. The other way to contribute into a Roth or to put money into a Roth is to simply convert this money. If you have money sitting in this environment, you can simply move it into the Roth environment to never pay taxes on this again. One word of caution, whenever a dollar leaves this environment, you are subject to taxes. You’ve never paid taxes on the money sitting here. You will owe taxes as the money leaves. The IRS has certainly not forgotten that. Another word of caution. In my example, if you have a million dollars sitting in here. And if you move it all up here, well, you might get a very nice Christmas present from the IRS because that will push you into the highest of tax brackets currently sitting at 37%. When you add on state tax, you very well might lose half of your savings simply by doing that. So we certainly don’t suggest moving all of your money. In many instances, it makes sense to move some of your money. If you don’t have an income limit, it may make sense to contribute money. There are lots of strategies again on how one can get money into a Roth environment. There is not a one size fits all approach and that’s why I would recommend again to anyone looking to do this or anyone that feels as though this is applicable to their situation to talk to a professional to get some professional guidance on which combination of strategies you can employ for yourself. To get to the result you want to get to and find yourself in a tax advantaged position rather than a tax disadvantaged position before you get to the age where it’s too late to do something about it.

Kathryn: I want to thank you so much Sumit for taking the time to really dive into all of this information. There are so many questions, and I know many of you still have questions. That would be the reason that now is the time to schedule a free financial assessment with someone like Sumit, one of our financial advisors.

All of the advisors here at Pure Financial are certified financial planners. We’ll take a deep dive into your entire financial picture. You’ll learn investing strategies that minimize risk and maximize return. You’ll learn to protect yourself from market volatility, inflation and rising healthcare costs, all the things that we kind of touched base on here. You’ll find out how to legally reduce taxes now and in the future and how to choose a retirement distribution plan that’s right for you. Because as Sumit said, there’s so many different ways that you can do that. This is no cost, no obligation, one on one comprehensive financial assessment, and it’s tailored for you. We encourage you to give us a call. Click on the link. We are a fee-only financial planning firm. We don’t sell any investment products and we don’t earn commissions on anyone. If we refer you to somebody, we’re not getting a kickback. Pure Financial is a fiduciary. Meaning that we’re required by law to act in your best interest. Pure Financial headquarters is in Southern California here in Mission Valley, San Diego. We have four offices in Southern California and offices in Denver, Seattle, and Chicago, but you can meet any of our advisors, any of our experienced professionals online via Zoom like you’re doing right now. No matter where you are, just click on the link and schedule your free financial assessment for a day and time that works for you.

Thank you so much to everyone for being here. We appreciate your attendance.  Sumit thanks for all of your expertise and all the great information that you’ve given to us.

Sumit: Thank you, Kathryn. Thanks and congratulations again to everyone for taking this important step in building your financial future.

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