Milestone 6: Invest for Flexibility
Before we get into Milestone 6, I want to bring attention to the fact that if you’ve reached this point on your financial journey, the heaviest lifting is done.
By now you shouldn’t have any toxic debts eroding away at your net worth, you should be sitting on a healthy emergency fund for rainy days, and you’re saving and investing enough to reach your goals for retirement.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Take a minute to celebrate how far you’ve come because you are doing far better with your money than most Americans ever will.
With that out of the way, there’s a new challenge to address: you have taken care of yourself, now what should you do with the excess?
The answer to this question is very goal-dependent.
- Do you want to try to push your retirement date forward by saving even more?
- Do you want to set aside some cash for your kid’s education? (see Milestone 7)
- Do you want to start a new or encore career?
- Are there places you’ve always wanted to travel to, but didn’t have the money before?
- Would a renovation make your home more livable or would you prefer to live somewhere else entirely?
- Have you dreamed of owning a vacation property or a real estate investment?
- Is there a cause or charity that you’ve always wanted to support more? (see Milestone 9)
In summary, Milestone 6 is where you can start to dream a lot more and begin to really enjoy the benefits of the self-discipline you’ve had through Milestone 5.
And because these dreams of yours can vary significantly, flexibility should also be a trademark at this stage in your financial journey.
Here are several points to consider as you evaluate how you want to begin using your excess cash while keeping flexibility at the forefront.
1) Keeping Stuffing Those Tax-Advantaged Accounts
Milestone 5 is to save 15%-25% in tax-advantaged retirement accounts.
If you have money available beyond this 15% to 25% range and there’s still room in your tax-advantaged options for saving and investing, these accounts are still the most efficient way to save and invest.
If you don’t have any other need for the money, then by all means, continue to contribute to these accounts.
The major drawback of putting money that’s above and beyond your retirement needs into these accounts is that it’s generally difficult to gain access to this money again before you reach age 59.5 without paying significant early withdrawal penalties.
If you’re comfortable waiting until 59.5 to fund your financial goals, then this isn’t a problem.
However, if you want to pursue some of the items in the bulleted list above before you turn 60, then there are other options you should consider.
2) If Not Tax-Advantaged, Then Where?
If you think you’ll want access to at least some portion of your money before you turn 59.5, there are a couple of options you can consider.
Standard checking and savings accounts are the first one I’ll discuss. They provide the flexibility we’ve already mentioned and do so in what will typically be an FDIC-insured account.
Even if you don’t stack up loads of cash in these accounts, you’ll at least want a checking account to stage money for immediate and short-term needs.
The primary challenge of standard checking and savings accounts is they’re not likely to provide very impressive interest rates, if at all.
Also, if you allow the balances in these accounts to grow to significant sums, then you could be missing out on a great opportunity to generate more cash by seeking higher returns elsewhere.
In light of this, I would recommend opening a taxable brokerage account to give you both the flexibility and security you’re hunting in this financial stage along with the opportunity to invest and increase your net worth even more.
Taxable brokerage accounts give you a wide range of investment options from cash to bonds and equities, while also providing the convenience of easily transferring money in and out of the account as needed.
You can open a taxable brokerage with hundreds of companies, but I would choose an option that offers a wide variety of diversified mutual funds and/or exchange traded funds (ETFs) with reasonably low expense ratios and trading fees (if they charge any).
Vanguard and Fidelity are the two best options in my opinion, but there are many others.
I will go into much greater detail about investment options later.
3) Can I Skip Ahead?
As you look down the Next Dollar Roadmap, you may have noticed that saving for your kid’s education and paying off remaining debt come after Milestone 6.
I did arrange the Milestones in the order that I think is optimal for general, overall financial wellness, but from here on out the order isn’t as significant as Milestones 1-5.
Rearranging Milestones 6, 7, & 8 is like moving dessert before dinner.
I know there are reasons you shouldn’t do that, but at this point in your life, you’ve illustrated enough maturity that you can trust yourself to do things the way you want.
The only word of caution I would give is to be sure you think carefully about what is most important for you to do next. Take time to think about it and talk it over with the people in your life who know you well and can challenge you to think about things critically.
Just because you have excess cash now doesn’t mean you won’t have any regrets about how you use it.
And don’t forget that you can do more than one thing at a time now. The only limit is the amount of extra cash you have.
4) Can I Take on Debt to Fund My Dream?
I don’t love the idea of taking on additional debt at this stage in your life, but I’m not going to say never.
Here are some questions to ask yourself before diving in.
- Is the debt for an appreciating asset?
- Is this secured debt?
- Is the payment on the debt, combined with all of my other debt payments below 30% of my monthly income or less than 3% of the amount of my net worth outside of my retirement savings (like cash and brokerage) and primary home? (In other words, do I have enough liquidity to easily service this debt?)
- Is the interest rate on the debt within 3% of the current 10-year treasury yield?
In summary, sure, there are ways to responsibly take on debt at this stage in your life and I can understand not wanting to wait until you’re 75 to cashflow your dreams.
However, it takes a lot of work to get to Milestone 6 and I don’t want you to risk it due to a sudden lack of focus. Be careful.
5) If I want to Invest My Excess Outside of A Retirement Plan, Where Should I Put It?
I hate it when people answer questions this way, but the truth is it depends.
Mostly, it depends on when you plan to use the money.
If you have plans that are less than 5 to 7 years away, you should use either fixed-income securities like bonds or cash equivalents like money markets to earn some interest while preserving your principle.
Five years just isn’t enough time to recover from a significant market dip, so stocks are not a prudent option for such a timeline.
If your goals are 7 or more years down the road, stocks (like mutual funds and ETFs, not necessarily individual stocks) are certainly an option worth considering.
Let’s walk through several of these investment options to highlight when and where they may be appropriate to own.
Treasuries
“Treasuries” is a broad term. It could include T-Bills, T-Notes, Treasury Bonds, I-Bonds, and TIPS, among others.
Ultimately, treasuries are debt securities issued by the United States Treasury. You give them cash, they promise some sort of return.
Typically, yields from treasuries are not going to appear all that impressive because their risk profile is about as low as you can get.
It gets kind of complicated, but ultimately there are a lot of people competing to buy available treasuries because of the level of security they provide. As a result, the Federal Reserve doesn’t have to provide exciting yields in order to attract investors.
A low-risk, mediocre reward is sort of the point.
TIPS and I-Bonds are good for protecting your principal from inflation, but little else quite frankly.
T-Bills, Notes, and Bonds all provide a guaranteed rate of return depending on when you bought them.
T-Bills are coupon-free bonds that are bought at a discounted price from their par value and can be issued with maturities of 4, 8, 13, 17, 26, and 52 weeks.
They are auctioned online at Treasury Direct on a weekly basis with the exception of 52-week T-Bills which are auctioned every four weeks.
Similarly, Treasury Notes and Bonds can be bought with maturities of 2, 3, 5, 7, or 10 years for Notes and 20 or 30 years for Bonds. Notes and Bonds pay a yield to their owners every six months and are sold at par with a promised yield.
Truthfully, if you want to own treasuries, it’s easier to just buy them inside of an ETF or mutual fund.
Corporate Bonds
I’m not going to dive deep into the weeds here on bonds, but we do have another post about bonds that you can check out if you want to learn more about them.
Put succinctly, bonds are debt.
A bond is almost always issued at a value of $1,000 (the issue price) which is what you give to the bond issuer for the pleasure of holding their bond.
In return, the bond issuer pays you some promised yield (coupon rate) at a regular interval (usually every six months) for some number of years (the maturity date).
Once the bond matures, you are paid the par value of the bond (usually the same amount as the issue price), and the deal is done.
I just want to make a couple of quick points about bonds.
First, not all bonds are created equal. Many have a relatively low risk of default, but many are incredibly risky.
For some reason, in the investing world, we have grown accustomed to referring to bonds as “low-risk” and stocks as “high-risk”. This is simply not accurate.
While I can see a valid argument for bonds being less volatile than stocks, volatility is only one component of risk. There are many other things to consider.
Second, it is much easier to purchase bonds that are held within a mutual fund or ETF than it is to go out and buy bonds on your own.
Just how much more difficult is it?
I wouldn’t know because I’ve never bothered to try buying bonds outside of a mutual fund or ETF. I’ve never seen the point.
Municipal Bonds
Municipal bonds (muni’s) are bonds that are issued by municipalities to raise funds for projects like new roads, bridges, or schools.
The key characteristic of muni’s that their yields are not taxed at the federal level (and many times, not the state or local level either).
If you have significant assets and are looking for a way to generate regular, tax-free income from them, muni’s are a very popular place to look.
Again, you can buy muni’s directly or purchase them within a mutual fund or ETF.
Stocks
Stocks are a portion of ownership in a corporation.
Companies issue stock as a way to raise capital. Once the shares are issued, they can be traded on exchanges between people or organizations in a stock market.
Of course, individuals have to trade through a brokerage which trades in the exchange on their behalf.
The prices of stocks in markets go up and down based on what people are willing to pay for each share of stock. This is completely unpredictable.
If there’s any one point you should understand about stocks, it’s that you can’t predict their performance in the short term without information other people don’t have. DO NOT TRY.
And if you have information others don’t, then don’t trade based on that either or you’ll wind up in jail. Right, Martha?
“So, Curt. If stocks are so unpredictable, why should I own any?”
Great question. The answer is that history has shown that portfolios that hold a broadly diversified basket of stocks for long periods of time outperform other investments with similar risk profiles. (I’ll add that stocks are also a very low-hassle investment.)
In other words, if you buy a diverse bunch of stocks and leave them alone for a long time, their returns are hard to beat.
And diverse is a key word here because single stock ownership is incredibly volatile and risky.
The easiest way to capture broad market diversification at a low cost is to use mutual funds and ETFs.
Mutual Funds
Legally speaking, mutual funds are a type of company.
They buy up large amounts of stock, bonds, or other equities and the value of the fund (known as the net asset value or NAV) is based on the value of the underlying assets in the fund.
When you buy a share of a mutual fund, you’re buying a stake in the fund corporation and thus, all the assets it holds.
That also means you own a share of any appreciation the assets experience as well as any taxes and/or expenses that are owed in the process of operating the fund.
Mutual funds always have some stated investment strategy designed to focus on a market segment, investment class, asset type, commodity, tax treatment, and/or index which attracts investors based on their own personal investment goals. These are stated in a fund prospectus.
The major draw of mutual funds is that they provide broad diversification and consolidate it into a single asset.
This is very convenient for investors.
As you look for mutual funds, here are several things to consider:
- Does the fund strategy and prospectus align with my investment goals?
- Is there sufficient transparency regarding the assets that are held by the fund?
- Are the expense ratios in line with funds that have a similar focus and/or strategy?
Exchange Traded Funds
ETFs are similar to mutual funds in that they consolidate a broad group of securities or assets into one investment.
The key difference between ETFs and mutual funds is their structure.
When you buy an ETF, you buy a tradable share of the ETF that holds the assets instead of owning a portion of the actual assets in the fund.
As a result, ETFs can be traded throughout the day in an exchange whereas mutual funds are traded once daily according to the NAV at the end of each trading period.
The ability to be traded on exchange means the price of an ETF can drift above or below the actual, real value of the assets that are held by the fund.
To keep the ETF price closely aligned with the assets it holds, each ETF has an Authorized Participant or “AP” who trades the fund or assets held by the fund through processes known as creation and redemption.
When an ETF is priced at a premium (meaning the ETF is trading above the value of the underlying securities), the AP can buy shares of stock from the open market and “sell” them to the fund in exchange for shares of the ETF.
This increase or “creation unit” of available shares in the ETF will cause the price to fall.
Conversely, if the price of an ETF is trading at a discount (meaning the ETF is trading below the value of the underlying securities) the AP can buy shares of the ETF from the market, and then exchange those shares for stocks owned by the fund. This is known as redemption.
There are several benefits ETFs provide:
- You can trade them any time the market is open, just like regular stock.
- Because ETFs don’t have to sell assets within the fund to pay exiting shareholders, their transaction costs tend to be lower.
- ETFs are also typically more tax-efficient than similar mutual funds.
Real Estate
If you’ve ever considered owning real estate as an investment, Milestone 6 is the first time you can prudently consider it as a possibility because you should now have enough cash available to cautiously step into being a landlord.
The fact is real estate can be a very rewarding and lucrative investment and this is especially true if you utilize leverage to finance the purchase of a property.
This is best illustrated through a basic cash-on-cash evaluation.
Cash on cash is the amount of cash returned from a given investment over the amount of cash put into the investment.
Let’s look at an example.
Suppose Larry Landlord buys a house for $100,000. He puts 20% down to purchase the house and rents it to a tenant for $1,000/month. Larry pays $500 for the mortgage each month and pockets the rest.
Larry’s cash on cash is $6,000/$20,000 or 30%. The $6,000 from 12 months of $500 net profit and the $20,000 is the total cash he had to pay for the down payment on the mortgage.
Thirty percent is an excellent rate of return.
However, if Larry had paid for the entire value of the home in cash, his return would have been $12,000/$100,000 or 12%.
That’s not a bad rate of return either, but it’s only 40% of the return on cash you’d have utilizing leverage.
This is a very simple example and odds are you won’t be able to charge 1% of your investment value in rent each month, not to mention that I excluded other expenses like maintenance and taxes, but I hope it provides a glimpse of what’s possible in real estate.
I would also urge you to do your homework before jumping into real estate. It is not for the faint of heart and shouldn’t be considered a passive investment.
If you want exposure to real estate but don’t want to be a landlord, look into Real Estate Investment Trusts or REITs. They work kind of like a mutual fund, but own portfolios of real estate.
Conclusion
I’m fond of pointing out that Milestone 6 is where you can really start to smell freedom.
It may not be total financial independence, but if you’ve come this far it’s much easier to see a clear path to the finish line.
It’s only a matter of time now.
Next up, Milestone 7: Prefunding Kid’s Education.
