• Stay Wealthy Episodes Referenced:
  • Stop Talking About Paying Off the National Debt
  • US National Debt: How Will We Ever Pay It Off?
  • Why You Shouldn’t “Buy the Dip” With Nick Maggiulli
• Three Articles Discussed:
  • 1) Nothing is Certain Except Debt and Taxes
    • The Federal Budget in Pictures
  • 2) Why Investors Missed Out on 15% of Total Fund Returns
    • Download the Mind the Gap 2024 Study
  • 3) Retirement: Freedom or Free-Fall

Retirement, Taxes, and Investment Underperformance

Taylor Schulte: Welcome to the Stay Wealthy podcast, I’m your host, Taylor Schulte, and today I’m summarizing and sharing key takeaways from three of the best retirement and investing articles I read this month.

The first article is about the future of taxes in this country, and specifically makes a strong case for why they will be higher.

The second is about why investors missed out on 15% of investment returns over the last decade.

And the third is a real-life account of what it actually feels like to be retired.  

To view the articles and additional research referenced in today’s episode, just head over to youstaywealthy.com/224.

The first article to share with you today comes from friend, author, and prior guest of the show, Nick Maggiulli. In fact, my conversation with Nick is one of the top 10 most listened to episodes on the podcast, so, if you haven’t listened or are interested in listening again, I’ll be sure to share a link to it in today’s show notes.

But in a recent article Nick wrote, titled “Nothing is Certain Except Debt and Taxes,” he makes a case for why taxes will be higher in the future. And while many listeners might share that same sentiment, what I’ve always appreciated about Nick is that he provides data to support his opinions…his blog is named “Of Dollars and Data” after all.  

In the article, Nick resurfaces a comment he recently made online that sparked some controversy. He wrote: “Maxing out your 401(k) when you are younger is almost always the wrong choice. The extra 0.5% per year isn’t worth locking up your wealth until old age.”

To argue his point, he recaps the key differences between marginal and effective tax rates, which are often misunderstood. Your marginal tax rate, he points out, is the tax rate that you pay on your last dollar earned. Your effective rate can be thought of as the “average” rate across all the dollars you earn.

Remember, the U.S. has a progressive tax system, where the higher the income you have, the more you pay in taxes. As a result, you’ll read or hear people make sweeping comments like, “I’m being taxed at the highest tax rate” or “I’m in the 37% tax bracket.” But just because someone is in the 37% tax bracket doesn’t mean they pay 37% on every dollar they make. 

Here’s how the IRS explains it:

“You pay tax as a percentage of your income in layers called tax brackets. As your income goes up, the tax rate on the next layer of income is higher. When your income jumps to a higher tax bracket, you don’t pay the higher rate on your entire income. You pay the higher rate only on the part that’s in the new tax bracket.”

So, ignoring deductions and credits, if you’re a single earner with an earned income of $50,000 this year, you’re marginal tax rate will be 22%. But since the 22% tax bracket for an individual earner begins at $47,150, you’ll only pay 22% tax on about $3,000. The other $47,000 will be taxed at 10% and 12%, and therefore your effective tax rate – the average rate across all the dollars you earn – will be much lower than your marginal tax rate of 22%. Your marginal rate is simply the tax rate you pay on your last dollar earned. 

The difference between your marginal rate and effective rate is important for many reasons, but specific to Nick’s article, the difference between these two rates is what influences people to make tax-deductible contributions to their traditional 401k’s and traditional IRAs. 

For example, if you make $100,000 this year, every dollar you contribute to your 401k reduces your taxable income by $1 and, in turn, each dollar contributed reduces taxes owed to the IRS by 22 cents. 

So, in this example, you avoid a 22% marginal tax rate on those contributed dollars and the money grows inside your 401k tax-free until you withdraw it. And what you pay upon withdrawal will depends on your future tax rate in retirement.  

Nick keeps it simple and assumes you’ll need to withdraw $100,000/year from your 401k in retirement to replace your $100,000 income you previously had when working. 

Ignoring deductions and credits, withdrawing $100k in retirement would result in an effective tax rate of 17% – 5% less than the 22% you would have paid if you skipped 401k contributions in your working years. You avoided 22% tax when contributing and only had to pay 17% upon withdrawal. And if you factor in deductions and credits,  your effective tax rate would actually be even lower than 17%, creating a tax savings that is potentially close to 8-10%. 

As Nick highlights, the math is definitely mathing, the math is correct and undeniable, he’s not arguing with that. His issue is that the math hinges on one major assumption – that income tax rates won’t increase much in the future. And he isn’t convinced we can easily make that assumption, mostly because of the state of the U.S. government’s balance sheet. 

Now, I’ve discussed the U.S. national debt situation a few times here on the show and addressed many of the common misconceptions. While not everyone agrees with what I’ve previously shared, it is important to point out here that Nick is focusing on the annual deficit part of the equation and not necessarily the total amount of national debt. And this is an important distinction. 

Think of the annual deficit like your own personal income and expenses. If you make $100,000 every year and spend $150,000 every year, you’re running a $50,000 annual deficit. You’re spending more than you make each year. This might be manageable for a few years, or maybe even 10 years depending on your unique financial situation, but over a long enough period of time, running an annual deficit will likely be problematic. 

This is very different than the national debt headlines, criticizing the US currently for having $35 trillion in debt. I’m not denying that it’s a large number or that there are issues with how the government has managed its debt and spending, but focusing on the total amount of debt only looks at one side of the balance sheet and doesn’t tell the whole story. It would be like me criticizing you for having $1 million in debt without knowing that you have $2 million in savings. 

So, back to Nick’s article, Nick highlights that the U.S. is currently running a $1.5 trillion annual deficit and that we have been operating with a growing deficit for the last 23 years. To him, it’s hard to imagine how we will be able to continue at this pace without increasing taxes. And if you share that belief, then why would you want to put so much of your money into a tax-deductible retirement account where the future tax rate on those dollars will be determined by future Congress that will likely be in dire need of revenue?  

And that future may not be too far away with the Trump tax cuts set to expire at the end of 2025. If those cuts do expire as it’s currently written in law, taxes across the board will immediately go up for nearly every American household. But then Nick asks, “what’s stopping Congress from raising them even more to feed their growing spending habit?” and points out that Ed Slott, a nationally renowned retirement and tax planning expert, shares his concerns as well saying:

“Whether your retirement is five years away or fifty, the single greatest threat standing in your way is taxes. Unlike losses experienced in the stock market, money lost to taxes never recovers.”

To round out his argument, Nick shares that effective tax rates – remember this is the blended average rate a person pays – effective tax rates are the lowest they’ve been in the modern era. If tax rates are low and government spending is high, he shares that there are really only two good ways out of this situation: 

1. Cut spending
2. Increase taxes

And since 50% of US Federal spending is on major entitlement programs like Social Security and Medicare, it’s hard for him to imagine that will be a likely scenario. 

While higher taxes aren’t ideal either, he argues that it’s likely better than a world where the U.S. defaults on its debt. 

If you agree that taxes will likely be higher in the future, then you might throw away the math used to support making tax-deductible 401k contributions. According to Nick, if effective tax rates increase by 10% in the future, then much, if not all, of the benefit of contributing to a tax-deductible retirement account and avoiding a higher marginal tax rate today goes away.

And for those that don’t think effective tax rates can jump 10%, it’s worth rewinding just a few decades. In 1994, the lowest marginal bracket was 15%, and the rate on the very next bracket jumped all the way to 28%. 

This is a significant difference from the 10%, 12%, and 22% brackets we currently have now. Which does bring to the surface a positive takeaway, which is that listeners who were aggressively contributing to tax-deductible 401k’s 30 years ago likely got an incredible deal – it’s possible that many of you avoided a 28% marginal tax rate back then to pay 15-20% effective tax rates today. 

To get more specific, Nick estimates that effective tax rates are about 6% lower, on average, today than they were in 1994.  And if effective rates went down by 6% in 30 years, he questions what’s stopping them from going back up by 6%, if not more, in the next 30 years? 

If they do go up, then it may be hard for younger retirement savers to justify locking their money up in employer plans for long periods of time just to get a tax deduction today that may result in them paying a higher effective tax rate upon taking withdrawals in the future.

A large percentage of this shows listeners are nearing retirement or in retirement, so it may not be very relatable to try and determine if it makes sense to make tax-deductible retirement contributions. Even if you do have a few more years of work left, it’s not a decision that is going to dramatically change the outcome of your long-term tax bill at this point. 

But, as I alluded to earlier, and as I’ve discussed in prior episodes, the expiration of the Trump era tax cuts (aka the Tax Cut and Jobs Act) does present an opportunity to potentially get more aggressive with Roth conversions in 2024 and 2025. 

With 2024 being an election year, it’s anyone’s guess how the expiration of the Tax Cut and Jobs Act will be handled by the new administration that takes over (because, you know, nobody wants to take the blame for higher taxes), but Nick does make a compelling case for why it’s hard to imagine how tax rates can continue to stay this low for longer. 

If you want to read the full article and review the data used to support his arguments, I’ll link to it in today’s show notes which again can be found by going to youstaywealthy.com/224.

Ok, the second article to share with you was published by Morningstar and is titled, “Why Investors Missed Out on 15% of Total Fund Returns.” This article is a recurring annual article that Morningstar publishes alongside their annual Mind the Gap study. For nearly two decades, Morningstar has been studying what they refer to as the “Investor Return Gap” (it’s also commonly referred to as The Behavior Gap), and last month, they released the most recent installment of the research showing that investors lost out on about 15% of the returns their fund investments generated over the last 10 years. 

To avoid any confusion, the bulk of this study is specifically comparing publicly available mutual fund returns to the returns that investors in those funds actually realized. It does provide some data about ETF returns compared to mutual funds, but for the most part, the study is centered around mutual funds and doesn’t measure the investor return gap for individual stocks, private investments, or other products like separately managed accounts. 

However, I would argue that a similar investor return gap exists in every product type – that it has less to do with the chosen investment vehicle and more to do with the emotional and psychological challenges of investing our hard-earned money in the markets. The investor return gap also has a lot to do with the type of asset categories the investor is invested in, as shown in the study.

For example, the investor return gap is wider in asset classes like nontraditional investments and sector funds than it is in asset allocation funds or plain vanilla U.S. equity funds. 

So, again, the study is comparing the total return of mutual funds to the actual return realized by investors in those funds. The total return of a fund assumes an initial lump-sum investment that’s held until the end–but, as you and I both know, that’s not how most people invest. We make an initial purchase of a fund, add some money, withdraw some money, maybe sell a big chunk, then maybe buy a little more. 

Given you likely don’t just make a single fund purchase and hold for a long period of time, your return will never be the same as the buy-and-hold historical return shown on a mutual funds brochure. Your return will always be unique to you. It’ll be whatever your average dollar earned while it was invested, taking into consideration the timing and amount of your buys and sells. If you buy high and sell low, your return will be lower than the buy-and-hold return. 

Sometimes buying high and selling low is unavoidable– but most of the time, buying high and selling low is a result of our emotions and irrational behavior getting in the way of our long-term investment plans. And that’s primarily what this Morningstar study attempts to better understand. 

These are my words, not theirs, but I think the more we can understand the “why” behind this “behavior gap phenomenon, the more we can hopefully mitigate the negative effects, and that’s precisely why I like sharing the results of this study with listeners every year. 

The first thing that Morningstar reported in this year’s study is that the results are broadly in line with prior year studies. That the investor return gap continues to persist. That investors continue to buy high and sell low, mostly because they get greedy when things are going well and fearful when the markets and economy hit some bumps in the road. 

Getting into some of the details of this year’s results, as I’ve already mentioned, investors lost out on around 15% of the funds aggregate average total returns they invested in over the last 10 years ending December 31, 2023. More specifically, this means that fund investors, on average, across all asset classes earned a dollar weight return of 6.3% per year while their mutual fund holdings had total returns of 7.3% per year. 

As briefly mentioned a few minutes ago, the widest return gap in this years study was in sector funds, where investors earned 7% per year on average, while their sector funds earned 9.6%, a 2.6% investor return gap. The next widest gap was in the nontraditional equity asset class like long-short and options trading funds, where investors earned 1% per year on average over the last 10 years and the nontraditional funds they invested in earned 3.3% per year, a gap of 2.3%. 

Just like prior year studies, the narrowest return gap was in asset allocation funds. Allocation funds are single mutual fund solution solutions that target certain risk/return profiles by investing in multiple sub-asset classes within the fund. 

A good example that most are familiar with is an age-based retirement fund, like the Fidelity Freedom 2040 fund, that has an allocation in place that is deemed prudent for someone who plans to retire in 2040. While it’s just one single mutual fund, it’s underlying holdings include multiple funds and asset classes across the world to match up with the stated risk/return profile. 

In other words, the single mutual fund does the ongoing investing and rebalancing for the investor, creating a simple solution for those that don’t have complex needs. According to this year’s Mind the Gap study, investors, on average, earned 5.9% in asset allocation funds over the last 10 years, and the asset allocation funds they invested in returned 6.3%, a gap of only 0.4%. The next smallest gap was in U.S. equity funds, where investors earned 10% per year and the mutual funds they invested in returned 10.8%. 

To round out the article and this year’s study, Morningstar shared 6  key findings that can help investors capture a greater share of their funds’ investment returns:

1. Less is more. All-in-one allocation funds handle mundane tasks like rebalancing and mitigate the need for you, the investor, to transact. The less you transact, the closer your long-term returns will be to your funds’ total returns. While these all-in-one funds aren’t a good fit for everyone, and have some flaws to take into consideration, they are a good option to consider if you have limited investing experience and/or don’t delegate your investment management to a professional advisor.

2. Context matters. Allocation funds are usually offered in employer retirement plans, while alternative and sector funds are not. Since employer retirement plans are often viewed as long-term savings vehicles, investors feel less inclined to make emotional changes. Participants in those plans are typically also limited to only a handful of investment options, preventing them from choosing something volatile that, as the study proves, will contribute to a wider investor return gap.

1. Routine helps. The findings in the study imply that making routine, or regular contributions to an investment account can be helpful in capturing more return. For example, contributing $1,000 per month on the same day each month removes the guesswork of investing and mitigates emotional trading activity. 

2. Volatility hurts. Year after year, the study finds that investors struggle to use volatile funds successfully. They chase investments that sound promising, only to give up quickly and move onto the next potential hot investment. The more a strategy rattles around, the more likely investors are to experience a return gap. 

3. Maintenance is not needed. Extra volatility introduces more maintenance. That is, investors in volatile funds are usually forced to make buy or sell decisions at what can be fraught times. More volatility, and more maintenance, does not help investors close the behavior gap. 

4. Convenience comes at cost. I didn’t share the results with you, but this year’s study did reveal that investors in Exchange Traded Funds experienced a slightly wider gap than investors in mutual funds over the last 10 years. The difference is so small, 0.1% per year, that I think Morningstar is getting a little nit-picky here. 

But the conclusion we might draw is similar to what was noted about sector and alternative funds. Like those asset classes, ETFs are not available in employer 401k plans, which are often treated as long-term buy-and-hold savings vehicles by investors. Also, unlike mutual funds, ETFs can trade intra-day, which certainly has its benefits, but also makes it easier for investors to react and transact, introducing the risk of a wide investor return gap.

If you want to dive deeper, I’ll link to this article as well as the full Mind the Gap Study in today’s show notes. I would also encourage you to read Carl Richards book, The Behavior Gap, which I’ll provide a link to as well. 

Ok, the final article to share with you is by retiree and writer, Tom Pendergast, who writes a blog called “Out Over My Skis.” Tom was a former cybersecurity executive and, with his professional career now in his rearview mirror, he is often asked by friends and family how it actually feels to be retired. To share his answer with everyone, he wrote this article titled, “Retirement: Freedom or Free-Fall.” 

Tom writes the following about retirement in his introduction, which I’m sure some of our listeners can relate to:

“The truth is, it’s thrilling and disconcerting and reorienting in ways that I never imagined possible. It’s a complete and utter change of direction from the last 40 years of preparing, building, acquiring, ascending, enduring. Sometimes it feels like I’m flying; other times it’s a free-fall.”

Tom acknowledges how difficult it is to write a typical article about his experience in retirement, an article that has a beginning, middle, and end. So, instead he shares a series of snapshots and stories that helps to better translate his experience and what he’s learned so far on his retirement journey. 

Instead of trying to summarize the different snapshots and stories Tom shared, I documented 5 key takeaways while reading his article – 5 themes that I think anyone who is planning for retirement or in retirement can benefit from. If you find these takeaways interesting or relatable, I highly encourage you to read Tom’s full essay, which includes not only his written word but also some great photos of him living his best life. 

Takeaway #1 for me was to Embrace the Complexity of Retirement. After decades in the professional world, retirement, to Tom’s surprise, proved to be this profound and unexpected shift. While it initially felt liberating and freeing, allowing for activities like reading, walking, traveling, and unstructured time, Tom shared how it also brought feelings of boredom and uncertainty. 

As I’m sure you can begin to imagine, the joy of having complete autonomy over your time and schedule can quickly turn into a challenge, especially for those of us who are used to having structure and purpose in our lives. 

The emotional journey in retirement is not linear; based on Tom’s written experience and what I’ve witnessed in working with retirees is retirement oscillates between euphoria and a sense of loss, highlighting the psychological complexity of this chapter of life that doesn’t get talked about nearly as much as the financial complexity. 

Takeaway #2 – Value Meaningful Work. At one point for Tom, his work was deeply satisfying and fulfilling – he felt valued and felt like his contributions were appreciated. However, changes in his work environment, driven by external forces like private equity making an investment in his company, led to a decline in his satisfaction at work.

The transition from meaningful work to a job driven by metrics and profits, now that he looks back on it, eroded his sense of purpose. As Tom alluded to, this experience underscores how much a fulfilling career can shape one’s sense of self and how the lack of meaningful work can introduce an identity crisis. It also highlights the deep connection between work and personal identity, and the struggle to redefine oneself in retirement, especially if unprepared for the shift. 

Takeaway #3 – Understand the Financial Reality of Retirement. As Tom notes, and as we’ve discussed here at length on the show, the shift from earning a regular income to living off savings is a significant, and often underappreciated change. There’s a difference between spending money when you know there’s another paycheck coming to spending money from a limited pool of resources in retirement. 

This financial transition also brings to the surface a broader theme of adapting to limitations in retirement, whether they are financial, social, or psychological. While you may have a healthy nest egg and don’t have a need for a fixed retirement budget, it’s important for everyone to understand in advance how retirement might reshape their financial habits, wants, and needs, to avoid any surprises.

Takeaway #4 – Let Go of Ego and Status. In the article, Tom gets vulnerable and shares about his confrontation with his own ego, particularly regarding money, status, and his possessions. He admits to having enjoyed the trappings of success – such as having a high-status job, making money, driving a nice car, and having the ability to indulge in luxuries. 

However, Tom found that retirement kind of stripped away these external markers of success, and he found that they ultimately became less important to him than the sense of mattering and contributing to the world. 

While you may not value financial status or driving nice cars or flying first class, there may be other forms of external validation that you’re attached to during your working career that may conflict with what you ultimately find important to you in retirement. 

Takeaway #5 – Pursue New Ways to Find Meaning. Ultimately, Tom’s heartfelt, vulnerable article is about the search for meaning in the absence of a traditional career. Tom has grappled with the question of how to matter in a world where his previous sources of validation—work, money, status—are no longer relevant. 

This search led him to a series of part-time jobs that are physical and hands-on, providing a different kind of satisfaction from the intellectual, technology and status-driven work of the past. The journey is ongoing, and he acknowledges that while he is no longer driven by ego and status, his quest for meaning remains. Tom concludes by writing: 

“I’m still the same person now that I’m retired, though I no longer swagger with self-importance. In fact, I understand now what I might have seen all along, had I not been so distracted by the chase: I am utterly unimportant and always have been. But that should not impede my search for more meaning, more mattering, more understanding. That’s the journey I’m on now. It’s the journey I’ve always been on.”

If you want to read Tom’s story in his own clever words, I’ll share a link to it in the show notes for today’s episode which, once again, can be found by going to youstaywealthy.com/224.

And if you have any unique retirement experiences of your own to share, I’d love to hear them. Shoot me an email at podcast@youstaywealthy.com. That’s podcast@youstaywealthy.com.

Thank you, as always, for listening and I will see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.