542: DIY Finance Friday: How to Create a Customized Path to Financial Independence

26:08The less you spend, the more cash you accumulate and the lower your asset base needs to be. So if you have a$3 ,500 a month mortgage payment for principal and interest, that's 40 grand a year. If you wipe that out, you need a million less dollars in your asset base per the 4 % rule to achieve financial independence, for example. That's one example of this. Again, bad math if it's 3%, but good math if it makes you feel free, right? Good in the context of freedom, bad in the context of the ultimate long-term end-of-life net worth number, which is usually not what people are optimizing for when they go through this exercise.

26:45Exactly. All right, Scott, you just alluded to portfolio imbalances or the middle-class trap of having most of your wealth in home equity and retirement accounts. How would you advise people in this situation who have their finance Friday numbers all set out, how would you advise them to craft their portfolio moving forward so that they don't have this reach retirement and have like nothing? The easy answer to the question is reduce your spending and continue maxing out. I'm going to use an example of a household that makes$140 ,000 a year, has a$400 ,000 or$500 ,000 primary residence and all of their wealth is in their home equity and their retirement accounts, maybe worth$600 ,000.

27:33Look like they're doing pretty well on paper, right? Many years have passed here with this, probably live a nice life here. Well, the issue is that you're not going to be able to use your 401k or your home equity to fuel your financial independence date, which is what we're all about on BiggerPocketsMoney, right? This is not, hey, here's how to plan for a traditional retirement and be set at that point. You're on track to do that. If you're listening bigger pockets money, you want something different, most likely. And in order to get something different, you have to make a change. Because you only make$140 ,000 a year, and you have a family and a house and all those kinds of things, you probably only have about$20 ,000,$25 ,000 of proceeds after expenses left over to invest in any given year.

28:18Let's imagine the late 30s, early 40s couple and family here, right? So what do you do with that? Well, what you are doing currently is paying off your mortgage and placing it all into the 401k. That's where the investment dollars are going. And if you want to achieve early financial freedom, something about that has to change. One option is to just reduce your expenses dramatically in all these other areas so that after maxing out the 401k or Roth, there's still tens of thousands of dollars a year left over to invest in after-tax brokerages or real estate. That can be very difficult and will require huge sacrifices.

28:56You can wait and just allow your fixed expenses, stop the goalposts moving, and your job and income hopefully to increase and use the additional spread to begin doing that, but that creates a decades-long journey to invest. So this person is kind of stuck, and it's a really hard situation. If they actually want to make changes, they have to make one of two pretty hard choices in most cases. One is sell their house and downgrade their lifestyle to some degree, consider house hacking or whatever, because that's really where half of their liquidity is going. And the other is to stop investing in the 401k, which can also be problematic because there's often a match and that's the easy button and that feels safe and secure.

29:37And it is a time tested thing. You know, you're going to get to financial independence in 30 years if you do that. But unless you're willing to do some sort of major sacrifice on the income or expense front, you're kind of stuck. And I think that's one of the things that I'm super passionate here about BiggerPocketsMoney is helping people avoid. You avoid that situation in the first place by never moving on that trajectory and saying, no, from the age of 25 or early in life, I'm going to set myself on a different trajectory so that my spread between my income and expenses is large after any retirement expenses.

30:07So I can invest that in after-tax stock accounts, or I can invest it in real estate, or I have enough liquidity to buy a small business, or try some of these alternative investments that can actually produce spendable cash flow early in life and allow you to declare your independence day in your 30s or 40s instead of at 65. And so that's the big middle-class trap. We don't have an easy answer for that at BiggerPockets other than don't set yourself on that trajectory from the beginning. So you're not in that position. And instead, your position looks like I have way less equity in my house, but way more in rental properties or way more in after-tax brokerage accounts.

30:48And I have a huge business and investment portfolio and relatively modest 401k bonds. That's where a lot of really good options come into your life, in my opinion. So how am I doing to explain the middle-class trap. I think you're doing great. And I am going to share that I myself am not in the middle class trap. We do have a fairly balanced portfolio in that some of our stuff is in retirement accounts and some of our stuff is in our home equity. I think it's like a third, a third, and slightly less than a third. I think we're more heavily weighted in after-tax stocks than 401k balances. but last year I turned 50 and I thought to myself, I'm sorry, two years ago, I turned 50.

31:37It's hard when you get old, your mind wanders. I thought you've been doing this for nine decades, Mindy. Who said that on one of the shows? I have been doing this for nine decades, but I'm only 50. The math doesn't work, but don't worry about it. Trust me. But when I turned 50, I was so excited because I could put an extra$6 ,000 in my 401k for the over 50 catch up. And then I finally realized, you know, all this money that I keep putting into my 401k is great. It's reducing my taxable income, but I'm going to be subjected to RMDs when I turn 72 or 70 and a half or whatever the age is for RMDs.

32:14I'm not there yet. So I contribute to my 401k. And oh, I assume that everybody knows everything I'm talking about. RMD means required minimum distributions. And when you turn, I want to say 72, 72 and a half, 73, something like that. When you turn that age, the IRS requires you to start taking distributions from your 401k, even if you don't need the money. So you are paying taxes on these distributions if they are traditional 401ks. And I don't want to take out money according to the government. I want to take out money according to me. So we have shifted, even though I get an extra$6 ,000 to max out my 401k with every year, we have shifted to more after-tax brokerage account investing.

33:10So if you find yourself in the middle-class trap, after you've looked through all of your numbers and you discover that your 401k balance is significantly larger than your after-tax account perhaps just shift a little bit. Again, you have to take into consideration your taxable income and what you're doing with all of your investments. It would be a great idea to talk to a tax strategist just to get a clear picture of what could happen to your finances in the future, but definitely start looking into after-tax brokerage account investing. Absolutely. And one of the things you said at the beginning of that I think is critical.

33:49you said my net worth is roughly a third a third a third in these buckets right and that is a critical exercise to do in the context of this plan so take that sheet of paper right the diy finance friday sheet that we've talked about with your income expenses assets and liabilities and then on the back of it flip flip over one of those pages and on a blank sheet of paper the back of it, think, okay, in five years, 10 years, pick your time horizon, I should have a net worth of X, right? Let's call it a million bucks. Where do you want that million bucks, right? And not many people who are starting from scratch will tell me, oh, I want that million bucks to be$500 ,000 in my$750 ,000 primary residence and$500 ,000 in my 401k,$10 ,000 in my savings account and$7 ,000 in my credit card balance.

34:38No one says that, right? They all say something different. And That's the problem that we find with middle-class traps. So many people are in that position, literally a millionaire, but feel completely trapped. You need to look at that and say, okay, that's what I'm on track for. What do I need to change to make that not become a reality? That's all we do on Finance Friday, essentially. That's all I do on Finance Friday is say, okay, I understand. I think I know where you want that to be, but let me take a couple of guesses. What do you like better here? Okay, now I've got that. They want a half real estate, half stock portfolio with enough cash to make them feel comfy.

35:14Okay, let's back into that. Now we can say, okay, that$40 ,000 a year are going to accumulate for the next 10 years, 400 grand. I'm going to deploy 200 ,000 of that into rental properties, probably two rental properties, maybe one, depending on where you live, maybe four if you're in a fortunate part of the country where you can actually afford real estate and rental properties with$50 ,000 down. You know, but that's how I back into the overall thought process. And it's as simple and as hard as guessing at what you're going to want 10 years down the road from your portfolio and then making the decisions there.

35:49And if one part takes off, like if real estate explodes, you divert more to stocks. And if stock market explodes, you put more into real estate, right? And over the time, you fine-tune backing into that pie chart you drew for your net worth statement at the end state. Perfect. Scott, thank you for clarifying what I was sort of thinking in my head, but not really. You're very good at that. And I did look it up while you were sharing that. Your required minimum distributions are starting at age 72 unless you turn age 72 after December 31st, 2022, which will probably apply to most people listening, in which case it's age 73.

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42:12That's PolicyGenius.com. All right. Welcome back to Bigger Pockets Money. Mindy, let's talk about the grind that we find many Finance Friday folks in the midst of. Yes. So the grind, Scott, is the middle, the point of time between discovering financial independence and actually reaching it. Scott, what is your advice for somebody to get through that grind? Yeah. So the grind is like, let's say we talk to somebody who has a net worth today of $250 ,000, is a couple of years into their career and wants to retire in 10 years with a net worth of$1.5 to$2 million, right? They're going to need to accumulate$75 ,000 a year, so this would be a relatively high-income earner.

42:56And this is not atypical of the guests that we would have on a finance Friday, right? And they need to deploy it pretty reasonably. And hopefully, the investment portfolio doubles in that time period. And that gets them pretty close and backs in. Well, during that time period, if they're watching their budget, working hard, enjoying life, they're just slowly getting rich. Mr. Money Mustache wrote a great article about this. He's like this, like, I remember reached out to him 10 years ago and it always has stuck with me. Right. And they were complaining about, Hey, I'm doing all the right things.

43:26I'm spending very little. I earn a good amount. I stick my money in index funds every month. And like, it just goes by and it ticks up. What am I doing wrong? And Mr. Mermostesh is like that feeling you have there, the dull, boring, obvious feeling, that's the feeling of getting rich. That's the grind, right? Like that's what it is, right? It is time passes and you add to the pile and you move towards your freedom number. in there. And so what we have with a lot of folks is, hey, you have one of two choices while you're in the grind. You can continue to upheave your life and make huge sacrifices, burn the midnight oil to start a business or side hustle or try to accelerate that journey.

44:04You can sacrifice and cut back on your lifestyle back as far beyond the point of reasonableness, or you can sit there and let time pass. And for many people, that's the most reasonable option. I just met with a couple recently in the Denver area. They're doing great. Multiple rental portfolio, probably a little bit under, you know, between one and a half,$2 million net worth, that kind of situation. A couple of properties in various stages of debt to equity. They're leveraged reasonably. They make good money and they're like, what do we do now? It's like, well, you can either start paying off your 3 % interest rate mortgages and generate more cash flow from your rental properties.

44:42You can sell your nice home and your nice neighborhood and house hack and move your kids out of school. Or you can say, great, we're doing great. We don't have to worry about accumulation that much anymore. Let this portfolio deleverage and not bite into the investment portfolio. And we're coast-fi. So there's all these options. That's probably the right option for that particular couple there. And that's totally okay in the context of the grind. but just know like sometimes some of you, many of you listening to the show perhaps, maybe optimize to the point of reason in your portfolio and it's just let time pass and start enjoying life.

45:18You did it. I don't know about how you feel about it, Mindy. I think that's great advice. What I advise people to do is to start planning what happens next. Don't be so caught up in the, I have to get to FI that you don't make any plans for afterwards. And unfortunately, this is actually really common. People are so, and like Carl and I found ourselves in this problem. We retired to nothing. We were gonna, like we have two kids. Trust me, the days get filled up, but we didn't have any real plans. We were just so focused on the number itself. So I want you during the grind to start thinking about what comes next.

46:02Create a bucket list. Put down everything, the wild things. If you want to climb Mount Everest, put it on the list. I don't want to climb Mount Everest. I'm not going to go with you. But if that's something that you want to do, put it on the list. Put little things on the list, like try out this new restaurant in town or try out these 75 restaurants in town. Whatever you want to do, put it on your list and start crossing those off now. One of the things that Carl and I really got, one of the best things that we got out of our conversation with Ramit was that we haven't been focusing on our current lives and how to make it better.

46:41So that's what we're doing now. We're using the money that we have to make our life better in the now. You can do that while you're grinding through. Does it matter if you reach financial independence in 2030 or 2031, if you have an amazing experience all the way to 2031, or you have a super crap experience all the way to 2030, pardon my French, focus on how you can make your life better while you're in the grind and focus on what you're going to do once you quit. Completely agree with that. I talked to another person recently who the household makes a really high income. This one was north of several hundred thousand dollars a year.

47:25And guy drives a 10 year old car. He's asking me if he should buy a$30 ,000 Tesla Model Y to replace his, I think it was 10 or 20 year old car. I think it had one 10 year and one 20 year old car. And I was like, dude, buy the car in that situation. Right. And like, that's, you know, like if, if the income was$80 ,000 a year, I'd say no, but there, you know, or no, that, you know, that's a real trade-off. But in this case, delaying financial freedom by one month to spend the next 10 years driving a better car is probably a really good trade-off. And so there's lots of those things of there's too much optimization that can happen in some cases, I think.

48:08And Mindy, you may feel that you may have made too many optimizations in prior years. I certainly probably did in a couple of cases. Yes. I think that we could have loosened our purse strings. We could have done, I mean, hindsight's 20-20, Scott. Of course, there's a billion things we could have done different or better. And you make the best decision with the information that you have on hand at the time. And at the time, the entire personal finance community was like, get to FI as fast as you can and be super frugal. And it's all about getting there. And now I think there's a lot more focus on it's all about the journey.

48:45And really, if you're going to be living for the next 10 years anyway, wouldn't you rather enjoy those 10 years? Absolutely. Mindy, I want to talk about another framework that I encounter a lot in Finance Fridays here, which is this concept of process or event in the world of personal finance. And occasionally, we'll come across couples, for example, who have radically different views on this, right? So, for example, we had maybe 250 episodes ago or something like that. We had a couple where the man wanted to build a business. He was always having a new entrepreneurial idea that was going to be the next breakthrough component here.

49:27And so they weren't saving. And his partner wanted to contribute to the 401k in there. And this can be a major conflict, right? Because, like, why are we putting all the money into the business when that's going to actually blow things up? and well, we're not actually seeming to get ahead because the business never takes off and we can't go here. And I just wanna chime in that I think they're both right, like those ideas, that there needs to be a formula for moving towards wealth. Like your spreadsheet needs to say, I'm gonna accumulate this much every month and that is gonna be moving me towards financial independence at a very reasonable clip.

50:04And if you're serious about getting there fast or have that entrepreneurial itch, you should be taking shots. on a regular basis and setting aside funds for that side hustle or small business. I think it's not one or the other for most people after the very first bits of the financial foundation are set up, like an emergency reserve and no bad debt, for example. But I actually think that that's a really good thing to keep in mind is if you're really craving financial freedom early in life, you probably should be doing both. You should be spending, your expenses should be highly controlled. You should have a stable source of income that generates a good spread.

50:45And there should be something in your repertoire that has the potential to really deliver a huge outcome for you. Again, like a small business, like real estate projects, like a side hustle combo with a small business that can take off. I really think that's the X factor that I see consistently across folks who really get there fast. But again, I think the trap that people can fall into is if they think it's all event. Only a few, usually and often in their 20s, somethings really seem to pull off a huge business outcome without having that underlying formula and strong financial foundation. What do you think, Mindy?

51:27Do you agree with that overall observation? I absolutely agree with that. And everything you were saying makes me think of your investment philosophy worksheet. It is a one pager and it is a document that we have. We will include it in our show notes. You can also find it at biggerpockets.com slash resources. It is called the investment philosophy worksheet. It is Scott's design and it just covers your goals, your cash management, your core tenets, your investment assets. asset classes. And this is something you've got a target date, bonus considerations. This is something that you work on. If you are not partnered up, you work on it by yourself.

52:09If you are partnered up, you work on this with your partner so that you each have an investment philosophy that you can agree on. And I really love this document. It's not something that it's a one and done. Scott comes back and revisits. Scott, is this an every year you revisit or is every quarter. My investment philosophy, I revisit about once a year. Once a year. So once a year, you just check in. Maybe you and your partner have decided, like Scott said, one of you wants to do a business, one of you wants to do 401k, you come to an agreement. Okay, we have 20 ,000, I don't like the term extra dollars, but we have 20 ,000 extra dollars to put towards this.

52:53And I would feel really comfortable with 10 ,000 going to the 401k and 10 ,000 going to the business. Great, then let's do that. And then next year, that business has all of a sudden gone crazy. It's exploded and you're making so much money. Maybe you can afford to put more into your 401k while also continuing to fund the business. Or maybe the business fell apart. It was not a good concept. It didn't pan out. It was the wrong timeframe, whatever. Then you can revisit and shift more into the 401k. But having it written down, having something that you both agree on, You know, Scott, we talked about having the money date.

53:30I absolutely think that's a great time to fill out your investment philosophy workshop. So that's another tool that you can use just to have conversations with your partner about your money and where you want it to go. Scott, something that I have in my mind, but I wanna hear your answer first. What is the number one consideration you're looking for when you see the Finance Friday numbers? I believe that you're on BiggerPocketsMoney or come to us for Finance Friday to pursue early financial freedom. So this is not how to retire at 65 starting at 30 with a million dollars by contributing$200 a month to your 401k.

54:09You want that? You could do that. This is how to get there early. And so one of the biggest considerations that I have is this concept of spendable liquidity. How are you actually going to harvest your portfolio in the future end state in a way that you're comfortable with retiring on early. And one of the biggest thing I'm looking for is that, are we moving towards a picture that looks like, hey, there's$100 ,000 in actual passive income that are coming into your life, typically? Or are we looking at a portfolio like this one that came into me a while back? This person was worth$3.5 million. They had a million dollars in stocks.

54:49They had a million dollars in real estate equity. They had a$750 ,000 life insurance policy, 250K in cash and 500K in home equity in their million dollar home with a mortgage payment of $3 ,300 a month. And like this person reached out to me and said, how do I generate 60K in passive cashflow? And it's almost like it's, it's not comical because it's, it's, this person is, is really struggling with this question, but it's like, if I handed you a pile of cash with$3.5 million, you can stick$1.5 million into your savings account at a bad bank that only offered 4 % APY and generate$60 ,000 a year in passive cashflow.

55:25But that's the thing that I'm always on the lookout for is, is your plan going to result in that person's portfolio where you're stuck making$250 ,000 a year and feel trapped? Like that's what I want to avoid for people. Right. And, and, and I'm always looking for that. And the cost is lack of optimization, That person was optimized. Stocks are optimized, but they produce no income. And most people don't want to sell equity in their stock portfolio at 40 to live off of. They want to spend income. Their real estate portfolio is levered to the point where it doesn't produce any cash flow. That optimizes long-term wealth, but doesn't provide any freedom.

56:11The mortgage is not helping them, and the life insurance policy don't get me started. But that's what I'm looking for when I'm looking for these portfolios. That's the number one thing I'm looking for is, is that your portfolio or is that where you're headed? And can I help you avoid that? Because if you're not building any wealth, we'll fix that first. But once you are building wealth, is it actually going to be congruent with this goal of freedom and bettering your life early, which I think is what we're all about here? How am I doing, Mindy? Well, you just said the G word, which is my most important consideration, is your goals.

56:42because your goals are going to drive the, I can't say advice, the suggestions that I would make based on your situation and your goals are part of your situation. I have this much income, this much expenses, this much debt, this much assets, and this is my goal. Well, if your goal is different than somebody else's goal with the exact same scenario, the advice is going to be different. I'm sorry, the suggestion. It's always a suggestion. It's just a suggestion. This is for entertainment purposes only. But your goal is what we're working towards. So driving you down, like think of a destination as you're driving.

57:22Google Maps is going to take you down this road if you're going to that spot. But if you're going over here, Google Maps is going to take you this way. So I need to know your end destination so I can give you the right map to get there. So I think it is very important to really think about what your goal is and make sure that it's attainable. If you're making$25 ,000 a year, you have$400 ,000 in student loans. You're not going to retire next year. That's just a fact. So make sure that your goal is attainable. And if it's not attainable with your specific current situation, then how can you change your current situation in order to get where you want to be?

58:04I love it. And Mindy, this is why you and I make such a good team is because when someone doesn't have a clearly defined goal, I give it to them. Oh, you're going to become financially free with this portfolio that could spend this at the earliest possible time. And I'm going to back into that and engineer everything backwards from there. And that is often what people want. That's what that's like what we're what we're doing here, but not always. And, you know, we get there. And I think you're much better than me about actually sussing out what what somebody wants at the highest level, because then you have a totally different engineering approach to getting there.

58:32if what I just said is not your goal. So yeah, absolutely. Scott, I used to feel really bad when we had different answers to a question because I'm like, oh, well, clearly Scott's right and I'm wrong. No, we're coming at it from different places. Scott is in his early 30s. I'm in my early 50s. He's the CEO of the company. I'm a lowly employee. And I don't mean it like that, But he's got a different set of life skills and a different set of thought processes than I do. I have two kids who are in their teens. Scott, they're both going to be in high school this year. Can you imagine? Daphne was starting kindergarten when I started at BiggerPockets.

59:17And now she's in high school. This is crazy. And Scott's daughter is one and a half? Yep. Almost. She'll be two in October. She'll be two in October. were. So we come at it from different places, but I think that's why it works so well, because we've got different ideas. And you might agree with me sometimes, and you might agree with Scott sometimes, and that's great. We're just giving you something to think about. So when you are thinking about your own Finance Friday, your DIY Finance Friday, try to think of what I would say. Try to think of what Scott would say. Feel free to post in our Facebook group, Bigger Pockets, no, Bigger Pockets Money Facebook group, which is facebook.com slash groups slash BP money, or post in the forums on BiggerPockets, email Scott and I, Scott at BiggerPockets.com, Mindy at BiggerPockets.com, and ask, hey, what would you do in this situation?

1:00:08Or how about this? Join us for a Finance Friday. Now, we have had Finance Friday guests who use their real name, use their video, share all their numbers. They're very transparent. But we have also had Finance Friday guests who use a fake name. I'm not going to tell you who it is because it doesn't matter. We've had people decide they don't want to use their video. We just want your story, your scenario, and we want to share your numbers. So if you would like to get our advice, we would love to have you. So if you would like to join us on a Finance Friday episode, apply at biggerpockets.com slash finance review.

1:00:45There is a place to let us know your level of anonymity that you would like to have. If you would like to have some anonymousness. Anonymity, I guess, is the correct English word, but you can also make it up. As long as you can use it in a sentence, you can make up a word. I just did, anonymousness. Let us know what you want. All right, Scott, this was super fun. I love talking about money. I don't know if you know that. Again, all of the resources that we've shared can be found at biggerpockets.com slash resources or linked to in the show notes, including the money date episode that I referred to just a moment ago and the episode where we walked you through Scott's investment philosophy worksheet.

1:01:24That was a lot, Scott. Yeah, that was, I love talking about this stuff. And hopefully, you know, you found some value if you're listening to the way, the frameworks that we use to approach the problems. They're not always going to be correct. Usually, not always, usually there's no, there's not some like tactical maneuver or advanced technique like a mega backdoor Roth or a conversion ladder or all this other stuff that's going on, usually it's very simple questions about how much is coming in, how much is coming out, where can we turn the levers and drive things forward, and what is the asset base going to look like at the time of the end goal?

1:02:04Those high-level decisions can be made on a piece of paper. they should be informed by the spreadsheet. But the strategy is usually very simple, or the simple ones are the most effective. The tactics only multiply it. So I love talking about this stuff. We'll get into the tactics occasionally, but it's just fun. It's just fun. It's fun to think about it. And it's fun to optimize for freedom and optionality in people's lives. All right, Scott, I think that's a great place to end. Should we get out of here? Let's do it. That wraps up this episode of the BiggerPocketsMoney podcast. He, of course, is the Scott Trench.

1:02:39And I am Mindy Jensen saying happy Financial Independence Day. BiggerPocketsMoney was created by Mindy Jensen and Scott Trench. This episode was produced by Eric Knudsen. Copywriting by Calico Content. Post-production by Exodus Media and Chris Beckham. Thanks for listening.