Ask Paula: How Do I Pay for Grad School?

30:41I'm losing out in two ways. I'm not getting that market upside. And the second thing that's happening, I'm forced to take money that could be contributing more money later to go into the stock market. I have to use it to repay that loan instead. So if I have enough money to do both, repay the loan and put money in the stock market, that's great. But in the vast majority of cases, what I've seen is that in real life, we take these dollars that could have been more money into the system and instead are repaying for this past mistake that I made. Do not borrow from your retirement for that reason.

31:18Now, to Rodolfo and to everybody else, this is why your super strategy doesn't work. And it's going to be very frustrating. The money you put into a 401k loan is usually pre-tax money. If it's pre-tax when it goes in, it's going to be after tax when you pay it back. You pay it back with money out of your wallet. What's that, Joe? You pay it back with money out of your wallet. I like the stage whisper on a podcast. It is. It's a secret the government doesn't want you to know. My least favorite phrase, by the way, the government doesn't care what you do. banks don't want you to know banks don't care what you know here's what they don't want you to know rodolfo it's a lot of work for not much benefit and let me explain this the money that rodolfo takes out that money is tax exempt now usually what i'd see is people take this money out they buy a car they buy a thing and the problem there paula is that if they've invested that money someplace else that they took out of the 401k loan, they have to repay it with after tax dollars.

32:27So let's say it's a pre-tax 401k. They repay more money because they got to pay the tax on that money out of their wallet to repay it because the money's gone. It's invested in a car, a real estate property, whatever it might be, the money's already gone. So you're repaying it with different dollars. But let's take Rodolfo's specific academic hypothetical. With Rodolfo's, unless they're assessing all the interest all at once, they're assessing all the interest all at once, this is a different deal. But he's going to go through all the paperwork. He's going to go through all of the legalese. He's going to get this loan.

33:06It's a pain in the butt. People have been through this, know this. It's a pain in the butt to get. And if the interest is being assessed daily, he's going through a ton of work for marginal utility for a little tiny, and then it becomes a best use of time argument. Like, why am I going to spend all this time maybe putting a smidge, the way my mom says it, a smidge more money into the 401k? So Joe, let's clarify. In Rudolfo's case, in this academic hypothetical, he's not using that money for any other purpose. He's holding that money purely for the purpose of making an additional contribution, which means that he is not repaying pre-tax money with after-tax money.

33:50So the tax consequences for Rudolfo's situation are actually not so dire. However, Rudolfo, the entire interest rate is not going to be assessed in one day. If you borrow$50 ,000 for 24 hours, you're not going to have to pay back$2 ,500 on a$50 ,000 loan that you've only held for 24 hours. It's very rare that a loan would have a flat fee lump sum interest rate that you accrue immediately the minute that you take out that loan. Typically, interest rates are assessed incrementally over time. So you might have to pay back an interest rate of 5 % per year, which means that the daily interest rate on that loan is going to be marginal.

34:47for you to be able to pay back$2 ,500 on a$50 ,000 loan at 5%, you'd have to hold that loan, which means you'd have to keep it out of the market, keep it losing money to inflation for a sufficiently long period of time such that you'd likely end up losing. At the best, it's a significant amount of work for just a little bit of arbitrage, right let's say he wins that use of time that use of worry that use of everything if he puts that money in the market and he gambles it in a one-year time frame it's a horrible gamble well 10-year time frame 20-year time frame it might be a better gamble but i mean with a five percent i know it wouldn't be because with a five percent annual interest rate in a specific year where we had a down market and an extremely low level of inflation under those circumstances He might win arbitrage that year.

35:47But if we think of expected value over a 10 or 20 year time frame, if we expect the market to over a long term annualized average go up, let's say, even 8 percent. But he's taking money out of his 401k, leaving it in cash, waiting until he accrues sufficient interest and then repaying it. He's losing. he's losing big time. And if he takes the money that's sitting outside the 401k and he invest it like it would have been invested in the 401k, he then is going to have to come up with the money, extra money to repay that's after-tax money on top of his pre-tax money because now the principal that he's going to repay from is not there anymore.

36:36And by the way, all this money that's interest as well, this after-tax money gets piled into the same account. So if it's a pre-tax 401k, it's going to get piled into the pre-tax account. Here's another kicker, Paula. That money then is counted as pre-tax money when you get to retirement and it's going to get taxed again. So just more insulting. There's just so many reasons not to do this, just not to mess with it. I think the biggest reason, Rudolfo, if we can reduce what we've just talked about to a singular reason. It is that this strategy couldn't be repeated four times a year for the very reason that the interest is going to accrue daily.

37:18And so if you were to hold this loan for 24 hours, as you talked about in your voicemail, the amount of interest that you would have to pay yourself back is going to be negligible. Even if you were to hold the loan for a month, the amount that you would pay yourself back is still going to be pretty negligible. And if you were to hold it for a year, then in the long term, you would lose that arbitrage game. And the slice that you win by comes back to what's the price of your time that you're investing in this. I just think the time versus the potential value, it's not there. As I see it, it's a negative EV decision.

37:56Yeah, agreed. Even if your time was worth zero, it would still be a negative EV decision in the long term. Sure. But it was an interesting thought exercise, so thank you, Rodolfo, for the question.

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40:57Speaking of 401ks, Joe. Oh, tell me there's more. Can we get more? There is. Yes, on the topic of 401ks. We're going to switch to talking about the Roth 401k. And that is the focus of our next question, which comes from Nandini. Hi Paula and Jo, my name is Nandini. I really enjoy listening to your podcast and I recommend it to so many of my friends. As an immigrant, I was struggling to understand even the basic things in financial investing and your podcast helped me a lot. I have two questions today. I recently learned that my company offers Roth 401k and I started contributing to it. My question is, if I already do Roth 401k, are there any advantages to do Roth IRA in addition to that?

41:55Other relevant information here is, currently I'm not maximizing Roth 401k. And if I have to open a Roth IRA account, I will need to do a backdoor Roth IRA due to income limits. My company also offers after-tax mega backdoor Roth account with a limit of about$44k. The money contributed to this account can be rolled over to either Roth 401k or Roth IRA. Based on this information, could you please suggest if there are any advantages to open a Roth IRA account? And my other question is, I often feel overwhelmed about investing. there are various funds such as index mutual funds and ETFs. What's the best way to identify which funds to invest in?

42:47Is the expense ratio and average returns the main factors, or do you advise looking at any other factors? Appreciate your time and guidance. Once again, thanks for everything you do. Nandini, thank you for your question. I'm thrilled to hear that this podcast has been so helpful for you. That makes me very happy. So thank you so much for saying that. To your question, from a tax perspective, a Roth 401k and a Roth IRA, including a backdoor Roth IRA, which is what you would need, from a tax perspective, there's no reason to favor one over the other. Tax-wise, you're good either way. There are, however, two reasons why you might want to prioritize a Roth IRA or a backdoor Roth IRA, which function in exactly the same way.

43:46There are two reasons why you might want to prioritize that over the Roth 401k. One, a Roth IRA gives you more flexibility in terms of your ability to access the principal. When you put money into a 401k, like we just talked about with Rudolfo in our last answer, when you put money into a 401k, it's locked up. You can't touch it. And if you do try to touch it, if you try to make a 401k early withdrawal, or if you try to take out a loan against your 401k, then there are all kinds of penalties, taxes. It's just not something that you want to do. By contrast, when you put money into a Roth IRA, you have the option to tap the principal, the contribution that you made, you have the option to access that money.

44:40I wouldn't ever recommend doing it. I would recommend keeping that money in there. But at least in a worst case scenario, if there was ever a real emergency, you could access your principal contribution to a Roth IRA without incurring penalties, taxes, or even just the paperwork hassle that comes from trying to tap a 401k. So that additional flexibility is one of two reasons why you might want to favor the Roth IRA. The other reason is that if your 401k is provided by an employer, oftentimes the investment choices that are inside of employer-provided retirement accounts are limited. By contrast, and of course, I don't know how good your employer-provided retirement account is.

45:31Maybe you have a fantastic one that has a bunch of wonderful options. If that's the case, then you're very, very lucky. But for most people, they have to compromise and get into funds that would be their second or third or fourth choice when they're shopping from the funds that are in their employer-provided account. By contrast, when you open a Roth IRA, you get to choose what brokerage you want that Roth IRA to live at. So if you choose Vanguard or Schwab or Fidelity, and I think all three of those are wonderful choices, if you choose any of those three, you're going to be able to invest that money in this wide array of index funds of your choosing.

46:20So to summarize, in a Roth IRA, the flexibility is greater and the investment options available to you are greater. I have nothing to add on that advice, Paula. The only place where I'd like to chime in is on just your financial planning strategy around having both of them. So the idea that your 401k might be limited makes the IRA good to be able to give you better diversification. So often when someone would look at one of my clients 401ks, it wouldn't look very well diversified. And the reason was we would just use whatever was really good, the asset classes that were really good inside the 401k.

47:08And then we would round it out with the other asset classes because you can get anything you want in most major brokerage accounts. We would then, at whatever firm we decided to land the IRA in, we'd use that to round it out. So if you looked at my client's IRA account, it would look not very diversified. You'd look at the 401k, it wouldn't look that diversified. But when you put the two together, which were there to achieve the same goal, you get this perfectly aligned mix of assets that met the efficient frontier, which by the way, leads me into her second question, which is, do you look at average returns?

47:49No, because then you will be chasing returns, which is always a mistake. If more money pours into what did well last year than any other asset class. And what's amazing is I feel like, Paula, people like you and I are screaming this from the rooftops on what feels to me like a daily basis. Do not do that. And yet it happens all the time. People continue to put money in what did well last year. We bet on, quote, what's done well lately. That doesn't work in investing land. The other thing that doesn't work is expense ratio planning. And the reason is, is that if you look at three indexes that you think do the same thing, there's the potential that they might not.

48:31Now, I'll give you an example. There was some big news that came out recently about a lawsuit against a brokerage house because of an oil ETF. because even the broker mistook this oil ETF as being the same as another oil ETF. And by the way, I wouldn't go into an oil ETF. Like if she's considering her asset allocation, I wouldn't even go there. But the point is, if you're just comparing average returns, that's a mistake. I also think comparing expense ratios. The first place to begin is what rate of return do I need? And then the second thing to look at is which mix of investments historically got me there.

49:15And I would look at something called the efficient frontier. When you and I had a discussion, when I was a guest on your podcast for the book, we went into this extensively. What is the efficient frontier and how do you find it? Where do you get there? And that's a pretty long discussion. And once you've done that, Paula, then you get much closer to what you need. And then we look at the expense ratios of the indexes that got you there. And we make sure we're not stepping in it by making sure we understand just a little bit. You don't got to know everything about everything, but you certainly got to know that you're not stepping in it by choosing the wrong ETF just because you looked at expenses.

49:53So I do, I do a little bit of due diligence, make sure it's through a big company. It's pretty straightforward for doing this, right? It should be pretty straightforward, but just, you know, it's a quick Bing search, right? Oh my goodness. A Bing search. I said that specifically to see your eyebrows go up, specifically for that reaction. You're welcome, America, the end of the world. You're welcome. But I would do a very quick search just to make sure there. But start off with what you need, what return you're going to target. Then look at how do I diversify appropriately to reach that. And then third, I compare expenses and go with the least expensive option that meets my goal.

50:36To that discussion about the efficient frontier, we'll link to that in the show notes, which you can subscribe to at affordanything.com slash show notes. Totally free. On the issue of the mega backdoor Roth IRA, don't be over-optimized. Make sure that you leave money available in case you need it soon. You don't want to have to jump through any hoops to get your money back. But beyond that, the more the merrier when it comes to the Roth. I think whatever she can afford to do that she knows she's not going to need right away, if she can move that money into a mega backdoor Roth position, I would do it.

51:15Just beware that tax. Make sure you have the money in reserve to pay that tax today. The only downside is lack of liquidity. Liquidity, yeah. Right. Say it all together. So thank you, Nandini, for your question. To summarize our answers, prioritize the Roth IRA, the backdoor Roth IRA, then the Roth 401k. And if there's money left over, then the mega backdoor Roth. And choose your investments based on the efficient frontier. Prioritize, of course, low cost, passively managed index funds. And so long as you are in passive index funds, I wouldn't over optimize the expense ratio. Expense ratio matters when we're talking about an actively managed mutual fund versus a passive index fund.

52:07But inside of the world of passive index funds, they're all going to be so close to one another that there's no reason to be splitting hairs. Thanks again for the question. And congrats on being so proactive about funding all of your Roth accounts. Roth accounts are my favorite types of accounts. Fantastic. Well, Roth or HSA? Come on. Oh, you know what? I like the Roth better. I mean, I love the HSA, but I like the Roth better. Gotta say. All the HSA fans go crazy. I know.

52:51Headlines. Shocking. Paula reveals. All right. Our last question today is about inflation and the 4 % rule. This question comes from Andy. Hi, Paul and Joe. Hope all is well. My name is Andy, and I have a quick question about how to calculate annual inflation with regards to how it works with the 4 % rule of thumb. I get that the 4 % rule of thumb is meant to be inflation adjusted, but where does that actual inflation number come from. I just assumed that we would use the average inflation from the previous year, but now I'm thinking that since it's an ongoing measurement, we would use whatever number is listed in December of the previous year.

53:37For example, according to an inflation chart that I'm looking at, the average inflation for 2022 was 8%. However, in December 2022, inflation was at 6.5%. To adjust the 4 % rule of thumb for inflation in 2023, do we use 8 % or 6.5 %? Or is there a different way that I'm not thinking about? Looking forward to hearing what's probably a shockingly simple answer to this question. Thanks again. Andy, thank you for the question. And I love the headline that you wrote in your question. The shockingly simple answer to the inflation question associated with the 4 % rule. There is a shockingly simple answer.

54:22It is revealed in all of its glory in episode 377, which is the episode in which we interviewed Bill Bengen, who is the creator of the 4 % rule. Bill Bengen, in 1994, decided to look at the performance of investment portfolios across 30-year time horizons beginning in 1926, so beginning from 1926 data. And so spanning 1926 to 1994, he looked at the performance of portfolios across all of those historic time periods, including the historic inflation that took place during that time. Now, a little bit of trivia. Can anyone tell me what the inflation rates were like in the late 70s and early 80s?

55:17Joe, you're old enough to remember. Oh, come on. You're old enough to remember the late 70s, early 80s, aren't you? I am, but I was 12 in 1980. However, I do know this. I know that CD rates were commonly paying 10%. The price of gold was through the roof. Inflation was rampant. And so interest rates were incredibly high. In fact, a lot of people with life insurance policies they bought at those times were locking in these whole life insurance policy rates on the cash value at 10 to 12 percent. Just screaming big numbers. So, yeah, you're looking at double digits. So here's a precise answer. In the 1970s, the inflation rate ranged from a low of 5.5 percent to a high of 14.4 percent.

56:11So in 1980, Joe, when you were 12, the inflation rate was 14%. Yeah, yeah. Fun fact, it was actually not the highest inflation rate that the U.S. has ever experienced. The highest inflation rate ever seen in the U.S., the all-time high, was 23.7%, and that took place in June 1920. So that escaped Bill Bengen's model because his model starts in 1926. But his model includes the longest stretch of heightened inflation that the U.S. has ever experienced. So in 1920, June of 1920, the U.S. had its sharpest peak of inflation. But if we want to talk longevity rather than severity, the longest stretch of heightened inflation was the 1970s.

57:01The model includes that. And the reason that I talk about this is because when you are mathematically modeling outcomes, there are two ways to do it. You could either model based on historic data or you could model a set of hypotheticals on a spreadsheet. What Bengen did to arrive at the 4 % rule was that he modeled based on historic data. And, you know, and that each methodology has its pros and cons. But what we know is that using a model that includes the double-digit inflation of the 1970s and 80s, we arrive at the 4 % withdrawal rule. Now, his model assumes that the portfolio is invested 50 % in an S &P 500 index and 50 % in intermediate term bonds.

57:47and assumes that all of this is in a tax-deferred account. If you want to read the original paper, it was published in the Journal of Financial Planning in 1994. We interviewed him on this podcast, episode 377. We will link to that podcast in the show notes as well. So the shockingly simple answer is every inflation rate that we have experienced from 1926 to 1994 is included in that model. so not to worry simplicity to the rescue yeah well simplicity and the fed for for all that we can criticize it for all that we can mock jay powell for at one point suggesting that inflation might be transitory i gotta hand it to him we are not the weimar republic yet all right joe i think we've done it.

58:44Wow. Already. You know, this is good. I feel like the through line on this episode was thinking, just rounding out your thinking a little more about your situation. In all four questions, didn't you feel like that was kind of the through line about maybe there's a little bit more of an answer? Right. Maybe there are alternate ways of doing it. Let's think laterally. Yeah. And it's funny how that's a happy mistake of a lesson. Not a mistake, but we didn't plan these four to have that through line. It's just the way it happened. Yeah. Every episode accidentally ends up with a theme. It does. It truly does.

59:28And this one's this think bigger. I could have done without the ranch dressing ice cream theme, but the rest of it was beautiful. You don't know what you're missing. And technically, Neither do I, because I've looked everywhere and just cannot. The supply chain, the supply chain on ranch ice cream. Come on, supply chain, get it together. Seriously. You know what we will also throw into the show notes? A clip of Stephen Colbert eating Hidden Valley Ranch ice cream. Stay tuned for that. Oh, must see TV. You look at the ingredients and they've got onion powder and garlic powder in the ice cream. Oh, oh.

1:00:07All right, Joe, where can people find you if they would like to know about more of your culinary delights?

1:00:17My brand of deliciousness is called The Stacking Benjamin Show, and it's available for samples or a complete meal every Monday, Wednesday, Friday, wherever you're listening to finer podcasts like The Afford Anything Show. And coming in June, Paula Pant is back. I'm back as of mid-June. I will be rejoining the Stacking Benjamins roundtable. It will be. Hilarity ensuing with Paula somehow. Somehow it appears, and I don't know yet, but as we are recording this episode, Paula, you're in a three-way tie for first place for the trivia contest, the annual trivia contest. Wait, aren't there only three contestants?

1:01:02Yeah, but you're in a tie for first, which also means you're in last, which is usually where you're at. Are we also tied for last then? It's usually. And tied for middle? She's like, I haven't improved at all. I finished last every year. But they've done well. You could be in first place by the time you get back. Anything is possible, Joe. We need a wagers on this. Someone's got to start putting some money on the line. Don't tell OG that. Don't, because he will. That'll be bad. Oh, then I will certainly tell him. I'll text him right now. Oh, man. You should give him your ranch ice cream against his.

1:01:40Maybe he's got to give you ranch-flavored ice cream. I would love that. I've been trying to find it everywhere. And then you've got to give him like Woodford. They probably cost about the same. If you're buying that ice cream on the black market, maybe they do cost the same. Who knows? All right. Well, thank you for being part of this community. This is the Afford Anything podcast. If you enjoyed today's episode, please share it with a friend or a family member. That's the most important thing you can do to spread the message of strong financial health. You can chat with other members of the Afford Anything community by heading to affordanything.com slash community.

1:02:20And you can find me on Instagram at Paula Pant, P-A-U-L-A, P-A-N-T. Don't forget to hit the follow button in your favorite podcast player. and while you're there, please leave us a review. Thanks again for tuning in. My name's Paula Pant. I'm Joe Salciai. And we will catch you in the next episode.

1:02:42Here is an important disclaimer. There's a distinction between financial media and financial advice. Financial media includes everything that you read on the internet, hear on a podcast, see on social media that relates to finance. All of this is financial media. That includes the Afford Anything podcast, this podcast, as well as everything Afford Anything produces. And financial media is not a regulated industry. There are no licensure requirements. There are no mandatory credentials. There's no oversight board or review board. The financial media, including this show, is fundamentally part of the media.

1:03:20And the media is never a substitute for professional advice. That means anytime you make a financial decision or a tax decision or a business decision, anytime you make any type of decision, you should be consulting with licensed credential experts, including but not limited to attorneys, tax professionals, certified financial planners, or certified financial advisors. Always, always, always consult with them before you make any decision. Never use anything in the financial media, and that includes this show, and that includes everything that I say and do. Never use the financial media as a substitute for actual professional advice.

1:04:03All right. There's your disclaimer. Have a great day.