The Simple Numbers Behind a Lifetime of Financial Freedom
Rob Berger
Financial freedom is a math and behavior problem, not an income problem — here is how to solve it.
Everything Berger wants you to walk away with
Invest $5,000 a year at an average return and after 45 years you'd have over $3.4 million. The math works because wealth comes from investment returns, not directly from saving. Saving just gets the ball rolling.
You have a choice every time a dollar passes through your hands: spend it or put it to work. Dollars invested in a 401(k), IRA, or paying down high-interest debt keep compounding for the rest of your life.
Samantha invested for just 10 years starting immediately and ended up with more than William, who invested for 35 years but started late. The best time to start is today. Delaying even one year costs thousands.
A higher savings rate accelerates wealth-building and simultaneously lowers the amount you need to be financially free. The Slingshot Effect: every dollar you don't spend both increases savings and decreases your freedom number.
Level 5 is five years of expenses saved — enough to walk away from a bad job. Level 6 is when investment returns equal your spending. Level 7 is 25 years of expenses — full financial freedom. Measure progress to build grit.
If you spend $50,000 a year, you need $1,250,000. Four percent of that equals your annual expenses. Financial freedom hinges on how much you spend, not how much you make — which is why celebrities go broke.
Multiply any recurring weekly expense by 752 to see what it would become in 10 years at 7% returns. Over 45 years, a $4 latte three times a week becomes $432,432. Think small, invest consistently.
Over 40 years, an initial investment doubles four times at 7% but five times at 9%. A 1% difference in fees or returns can cost nearly $500,000 over a career. Keep costs low and stay invested.
A cool new car becomes just a car in six months. A raise becomes a distant memory. Chains of habit are too light to be felt until they're too heavy to be broken. Spend deliberately, not from routine.
The five lies keeping people stuck are that freedom requires a big salary, takes 40 years, means expensive happiness, demands investing expertise, and that debt is unavoidable. None of them are true.
These notes are inspired by direct excerpts and woven together into a readable guide you can follow from start to finish.
By Rob Berger
Five common lies keep people from pursuing Financial Freedom. Once you see through them, the path forward becomes surprisingly clear.
This lie tells us we are destined to live paycheck-to-paycheck, and our minds play a trick that makes it easy to believe. Imagine somebody making $50,000 a year their entire adult life. Even saving 10 percent a year ($5,000), how could they ever become a millionaire? Over 45 years they would have saved $225,000. That couldn’t possibly grow to $1 million. Yet with an average investment return, $5,000 a year—about $416 a month—would accumulate to $3,421,620.11 over a working career.
Once you believe this lie, you don’t see Financial Freedom as a goal worth pursuing. Either you’ll never reach it (Lie #1) or you’ll have one foot in the grave when you do.
We so often spend money not from deliberate choice but from the habits and routines of life. Once these habits form, they are difficult to break. As Warren Buffett has stated, chains of habit are too light to be felt until they are too heavy to be broken.
Imagine spending no more than about 30 minutes a year to maintain your investment portfolio. That is genuinely all it takes with the right approach.
We each have a baseline of happiness. A positive event—getting a raise, buying a shiny new thing—may temporarily increase our level of happiness, but gradually we return to our baseline. That cool new car you bought six months ago is today just a car. The raise you received last year is a distant memory as you fret about whether you’ll get one this year.
If you are in your twenties today, you can use the principles in this book to retire in your thirties or forties. If you are in your forties or fifties with little savings, you can use them to retire “on time.” You can, if you choose, work a typical 45-year career and retire in your sixties or seventies—with a truckload of money. You can also use your Financial Freedom to empower you to do meaningful work you love, at any age.
Rob Berger speaks from experience: he retired at 49, and again at 51, and went back to work he loves at 52. Financial Freedom does not have to mean permanent retirement—it means having the choice.
Most people see each dollar that enters their lives as nothing more than a dollar. What they don’t see is the dollar’s potential. Every time a dollar passes through your hands, you have a choice: spend it or put it to work. Spending is of course necessary—housing, food, clothing are true needs. Cable TV, expensive cars, and gym memberships are wants. The distinction matters, though no judgment is implied.
As for the dollars you don’t spend, you can put them to work: deposit them in a savings account, invest in a 401(k) or IRA, or pay down high-interest debt. Every dollar you put to work is like an employee—the best kind. They never complain, never ask for a raise, never sleep or take time off. They work 24/7, and if you let them, they’ll keep working for the rest of your life.
Key Insight
Wealth comes from investment returns, not directly from saving money. You must save to get the ball rolling, but the vast majority of wealth comes from investment returns. That’s true for you and me, and it’s true for the richest men and women in the world.
The only change required is to invest your money. This doesn’t require working overtime, staying late to keep the boss happy, getting a second job, cutting out vacations, eating rice and beans every day, winning the lottery, or getting a raise. Just invest your money.
Think of the Money Multiplier as a moving walkway for your money. The longer you let your money ride, the faster the walkway goes. It consists of just three parts: Amount, Time, and Money (the return on your investments).
Time is the most powerful element of the Money Multiplier. If we assume a 9.3% return, one cent compounded annually would be worth $4,892,563.14 after 225 years. The same compounding that builds an avalanche of wealth works in reverse to multiply the losses for those who delay.
Consider two investors. Samantha starts investing $208 a month immediately after college and continues for 10 years, earning a 9.3% annual return. She accumulates $40,940.80. After year 10, she stops adding money but lets her investments continue to compound. Thirty-five years later her nest egg is worth $1,047,937.16. William, by contrast, waits 10 years before starting to invest the same $208 a month. He invests for 35 years—three and a half times longer—but ends up with only $660,135.60.
Principle
The best time to start saving and investing is today. Delaying even one year can cost you thousands of dollars over the long run. Delay for five, 10, or 15 years and the losses really add up. If you are late to the game, there is still hope—but start now.
Definition
The Rule of 752: Take any recurring weekly expense and multiply it by 752. The result is how much you would have if, instead of spending the money, you invested it for 10 years earning a 7% return.
These numbers get enormous over longer time horizons. Over 45 years, use the Rule of 36,036: a $4 latte three times a week equals $432,432. Cable TV at $25 per week equals $900,900. Eating out twice a week at $30 equals $1,081,080.
The takeaway is that small amounts of money, invested over time, turn into large piles of cash that can change your life. Seemingly insignificant changes in weekly spending can go a long way toward Financial Freedom. You don’t need a lot of money to start investing—even $25 a month will get you started.
Over a 40-year period, an initial investment will double four times at a 7% rate of return (once every 10 years), while it will double five times with a 9% return (once every eight years). Seemingly small differences in returns, multiplied over decades, produce massive differences in outcomes.
Key Insight
Instead of accumulating a Freedom Fund of more than $1.7 million, a “small” 1% difference in returns lowered the result to $1,213,503.86—a loss of $494,568.90. The rate of return on your investments matters enormously, and seemingly small changes have huge, life-changing effects over time.
Ultimate Financial Freedom comes when you can live off of your savings and investments without the need to work. We are conditioned to define financial success based on a fat paycheck, yet Financial Freedom hinges on how much you spend, not how much you make. That explains the all too common stories of celebrities, athletes, and lottery winners going broke—their expenses consumed all of their income and then some.
Financial Freedom is measured in levels, defined by how many years of expenses you have saved. Each level represents a concrete milestone that gives you the grit to keep going—a concept known as The Progress Principle.
Definition
The 4% Rule: Developed by financial planner William Bengen in the early 1990s, this guideline says you can spend 4% of your investments in year one of retirement, then adjust the amount each year by the rate of inflation. If you spend $50,000 a year, you reach Level 7 when you’ve saved $1,250,000. Four percent of $1,250,000 equals $50,000. You get the same result by multiplying your annual expenses by 25.
Action
Determine your current level of Financial Freedom. This requires knowing how much you spend each month—be sure to include periodic expenses such as gifts and vacations. For savings, do not include short-term savings earmarked for a specific goal like buying a home or a car.
Saving 10% was popularized by The Richest Man in Babylon (1926)—save 10% of every dollar and you’ll do just fine. Dave Ramsey espouses saving 15%. Senator Elizabeth Warren’s book All Your Worth recommends the 50/20/30 budget: 50% of income to needs, 30% to wants, and 20% to savings.
Save even 10% and you’re doing better than the vast majority of people—the average saving rate in the U.S. is around 6%, according to the Fed. There are many reasonable rules of thumb, and they can be a good starting point. But you should always think for yourself, making informed decisions about your finances.
”There is only one kind of shock worse than the totally unexpected: the expected for which one has refused to prepare.”
When your Saving Rate goes to 20%, your Spending Rate drops to 80%. Not only are you saving more, but you need to save less money to equal one month of expenses.
Principle — The Slingshot Effect
Every dollar you don’t spend increases your savings and decreases how much you need in your Freedom Fund to reach each level of Financial Freedom. The more you save, the less you spend. The less you spend, the faster you achieve each level. Your Saving Rate—and by extension your Spending Rate—is the key to unlocking a lifetime of Financial Freedom.
Over the past century or so, inflation has averaged just under 3%. Reducing the assumed 9.3% nominal return by 3% yields a 6.3% “real” rate of return (adjusted for inflation). When estimating the time it takes to reach Level 7, always use the real rate of return.
As the name suggests, in year one you can spend 4% of your investments. In each year following, you adjust the previous year’s spending by the rate of inflation. Think of it more as a guideline than a hard rule, but it’s considered a reasonably safe approach to retirement spending.
With a 9.3% nominal return, you might wonder what happens to the other 5.3%. Three factors eat into it: you must account for inflation by reinvesting the difference to help your portfolio keep pace with rising prices; you must account for stock market declines—actual returns are lumpy (some years up 25%, others down 25%) and your portfolio must withstand extreme bear markets; and you must account for a more conservative portfolio in retirement. Moving to a 60/40 or 50/50 stock-to-bond allocation lowers your expected nominal return below 9.3%.
Action
Take the amount you need to live on each year and divide by 4% (or multiply by 25). The result is your Freedom Fund goal for Level 7. Use the free spreadsheet at retirebeforemomanddad.com/FFCalc to estimate how long it will take based on your Saving Rate, rate of return, and current savings.
For extreme early retirees aiming to retire at 30 and never earn another dime, 3% or 3.5% is a better withdrawal assumption, since the money needs to last 60+ years. For someone planning to work until 80 with only 20 years of retirement, 5% or higher could work. These are extreme cases, and they don’t account for other income sources like Social Security or pensions.
Key Insight
How much you make doesn’t change the results. The time to Level 7 is a function of the percentage of income you save, the rate of return, and the withdrawal rate. If two people each save 10% and earn the same return, it takes them the same time to reach Level 7—even if one earns $50,000 and the other $500,000. The higher earner is saving more, but they also need a much larger Freedom Fund because they spend more.
A one percent difference in investment returns can add five years or more to the time it takes to reach Level 7. If pushed for specific guidance on how much to save, the answer is always: at least 20%.
The Latte Factor assumes you forego a daily $5 beverage, freeing up about $150 a month to save and invest. At a 9.3% nominal return over 45 years, that adds up to $1,231,783.24.
Principle
Every dollar you save has a Slingshot Effect—it increases your savings and it decreases your Freedom Fund goal.
What makes you happy? It’s a simple question—and one of the hardest in life to answer. Many people live their entire lives without ever answering it. Before reading further, answer it for yourself: list the top 10 things in your life that make you the happiest.
Key Insight
We shouldn’t be asking how much we need to make to be happy. We should be asking how much we need to spend to be happy.
”Do not save what is left after spending, but spend what is left after saving.” — Warren Buffett
Relying on willpower alone to save money rarely works. Willpower may get the job done for a time, but eventually you let your guard down. It’s just like dieting—by sheer force of will you may lose a few pounds, but as the pounds come off, willpower subsides, and eventually it’s all ice cream and fries. The same yo-yo effect can happen with money.
Write down every monthly bill you have, including the amount. So much of our money is spent without thought—especially when everything from the mortgage to utilities to cable is paid automatically. The goal is a complete list of all monthly expenses: rent or mortgage, credit card debt, car loans, school loans, all other debt, utilities, internet, cable, phone, streaming services (Netflix, Hulu, Amazon Prime, etc.), and insurance (car, life, health, homeowners).
Creating a complete list is critical—miss an item and you may miss an opportunity to save. Check your credit card and bank statements to make sure you haven’t forgotten anything. Remember: out of sight, out of mind.
While every situation is different, here are proven tactics: increase insurance deductibles; decrease life insurance if over-insured; move to a lower-cost cell phone provider; move to a lower-tier cable package; reduce internet speed; refinance debt to a lower rate; get a roommate; pay car insurance for six months instead of month-to-month.
Real-world examples from readers illustrate the range: switching cell phone providers to Mint saves $500 a year; negotiating internet pricing annually saves $30 a month; shopping at Aldi saves $30 per trip; moving to a studio instead of a two-bedroom high-rise saved $150 a month; biking to work instead of driving saves roughly $40 a month in gas and maintenance; cancelling a gym membership and buying home equipment saves $65 a month; making coffee at home with a French press and bulk coffee saves $70–$80 a month; switching to SimpliSafe at $15/month saves $270 a year on homeowner’s insurance; shopping house and auto insurance saved one family $3,000 a year, and the new rates included umbrella insurance.
Principle
If your employer matches retirement contributions: take advantage of the match. The best ways to save money are painless and require action just once.
Action
Conduct a Money Audit at least once a year. Be sure to automate any money saved so that it goes toward your Financial Freedom.
Now turn to what are called Lifestyle Expenses. The Latte Factor is a metaphor for how we waste small amounts of money on small things—a teaching method to get people to rethink how they spend money and realize they have more than enough to start saving.
Breaking a habit is painful at first. You might not be able to get your daily latte out of your mind. But after a couple of weeks, the craving adjusts—and then you don’t miss it. You don’t even want one. In the end, the Latte Factor isn’t about avoiding things that bring pleasure. It’s about making sure how you spend your money truly brings you the joy you desire. In many cases, we spend money out of habit, and the happiness is fleeting.
Key Insight
Small wins fuel transformative changes by leveraging tiny advantages into patterns that convince people bigger achievements are within reach.
”All life is an experiment. The more experiments you make the better.” — Ralph Waldo Emerson
Start with small questions: What if I skipped my daily latte? What if I took my lunch to work? What if I ate out less? Then ratchet up the boldness: What if I scaled back my vacations? What if I got rid of cable TV? What if I biked to work? Then go big-league: What if I got rid of one of my cars—or all of them? What if I downsized my home? What if I moved close enough to work to walk? What if I moved to a less expensive area?
Some of these raise immediate objections. But take time with them. What would you do without a car? You’d survive. The point isn’t to convince you to sell your car—it’s to invoke your imagination, to think beyond your current situation, to consider what at first seems impossible.
Here’s how much faster you’d reach Level 7 based on specific monthly savings (at a 6.3% real return): getting rid of cable TV ($100/month) gets you there three years faster; eating out less ($200/month) gets you there six years faster; going without a car (~$300/month) gets you there eight years faster. Combine all three for $600/month in savings and you reach Level 7 more than a decade sooner—about 30 years instead of nearly 43.
Action
Run 21-day experiments. This is a simple way to test not only whether you can put more money toward your Freedom Fund, but also whether the way you are living today really makes you happy.
Cars are the #1 Freedom Fund killer. Here is the average monthly cost of owning a new car, per NerdWallet: $523 car payment, $98 insurance, $146 gas, $99 maintenance and repairs, $12 registration, fees, and taxes—totaling $878 per month.
If you invested $878 a month at a 9.3% annual return: after 10 years you’d have $172,817; after 20 years, $609,257; after 30 years, $1,711,459; after 40 years, $4,495,003.
Some obvious caveats: not everybody can or wants to go without a car; even carless, you’d still spend something on transportation; not everybody buys new; you may pay cash (avoiding interest, but still losing the investment opportunity); and the $523 average payment doesn’t last forever—eventually the car is paid off. All true.
Still, buying a car every five years under these assumptions costs over $3.7 million in missed wealth-building opportunities over a lifetime. By driving a car longer, you add hundreds of thousands of dollars to your wealth—assuming you invest what you aren’t spending on the car.
Principle
Cars are expensive. Any way you can reduce your car expense can go a long way to supercharging your journey to Level 7. Freedom first, cars second.
At first glance, lending money to a company seems safer than buying part of it. When you buy a bond, you have a contract requiring the company to pay you interest and return your principal when the bond matures—that is, when the term comes to an end. If the company fails to pay, you can file a lawsuit and, depending on the bond’s terms, lay claim to the company’s assets to recover your money.
Bonds carry two key risks. The first is Credit Risk: the company fails to pay. You can sue, but if things go badly enough, the company may not have the assets to repay you even if you win. The second, and often more serious, is Interest Rate Risk. Suppose you lend $100,000 for 10 years at 7%, which was a competitive rate at the time. Two years later, similar bonds now pay 10%. You’re stuck earning 3% less than the going rate for eight more years. That’s why rising interest rates hurt the value of existing bonds.
Owning stock has clear potential negatives: you don’t receive guaranteed interest payments, you don’t have a contractual right to the return of your investment, profits may not materialize as expected, and the business could go under. However, the upside is uncapped.
Definition
Dividends are profits returned to a company’s owners. They are similar to interest paid to bondholders, with two key differences: a company is usually not contractually obligated to pay dividends, and unlike fixed bond interest payments, dividends can grow over time.
A bond is a fancy word for debt. When the government issues a bond, it borrows money from investors who purchase it. Bonds are sometimes called Fixed Income because most have a fixed interest rate paid on a predictable schedule. Savings accounts and CDs are also fixed income investments. Stocks, by contrast, represent ownership. When a company like Apple distributes profits, it declares a dividend paid out to you in proportion to your percentage of ownership.
If in 1928 you had invested $100 in each of three asset classes, by the end of 2017 your investments would have grown to: 3-Month Treasury Bills: $2,105.63; 10-Year Treasury Bonds: $7,309.87; S&P 500 Stock Index: $399,885.98.
Since 1928, three-month Treasury Bills have never gone down in value from one year to the next. Ten-year bonds have seen 17 negative years, with the worst being 2009 at −11.12%. Stocks have had 25 negative years since 1928—the S&P 500 lost 43.84% in 1931 and 36.55% in 2008.
Principle
In the long run, stocks perform better than bonds. In the short term, stocks are more volatile than bonds.
Broadly speaking, there are two types of mutual funds: Actively Managed Mutual Funds and Index Mutual Funds. There are many indexes that track both stocks and bonds—the Russell 3000 tracks 3,000 of the largest U.S. companies, the Wilshire 5000 tracks all stocks trading in the U.S., the S&P Midcap 400 covers mid-size companies, and the FTSE All World Index tracks over 3,000 companies in nearly 50 countries.
Key Insight
Over long periods of time, index funds outperform most actively managed funds on an after-fee and after-tax basis. In 2016, two-thirds of actively managed large-cap U.S. funds underperformed the S&P 500. For small-cap funds, 85% underperformed. Over 15 years, 90% of actively managed funds underperform their respective indexes. Since 2001, 89% of actively managed international funds underperformed as well.
Index funds are cheap, simple, and most outperform actively managed funds over the long run. They come in different shapes and sizes for both stock and bond investing.
Size (Market Cap): Generally, small-cap stocks have higher returns than large-cap stocks over long periods, but with greater volatility. Think of small-cap stocks as a wild roller coaster ride.
Growth vs. Value: Growth stocks are companies with rapidly growing revenue—like Amazon, Tesla, and Netflix. They are the high flyers, expensive relative to their profits. Value stocks are companies whose stock price is considered undervalued—often older companies like Ford.
REITs: A Real Estate Investment Trust is a mutual fund that invests in real estate—apartment buildings, retail space, commercial property, and even mortgages. An important detail: REIT funds are not tax efficient. They pay out a substantial portion of profits each year, taxed as ordinary income. If you invest in a REIT fund, do so inside a retirement account.
Commodity Funds: These invest in commodities like oil, corn, and gold, either directly or through companies whose performance depends on commodity prices.
Mutual funds that invest in corporate bonds issued by companies with shaky financials are called High Yield (or Junk) bond funds. To be clear, junk bonds are not junk—they have more risk but also potentially more reward. Bond funds also vary by duration: Short Term (less than three years, low interest rate risk), Intermediate Term (three to 10 years), and Long Term (more than 10 years).
”Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees.” — Warren Buffett
History tells us the lower the cost of an investment, the better it will perform in the long run. It’s counterintuitive—we are conditioned to believe we get what we pay for—but this is not true when it comes to investing.
Definition
Expense Ratio is the annual fee a fund charges, expressed in Basis Points (Bips). 100 basis points = 1%. Ratios range from a few bips (0.05%) to over 200 (2%).
There is a dirty little secret few people know: the transaction costs that mutual funds pay do not come out of the Expense Ratio. They are a separate, hidden fee—and not even the funds know what they will be until they actually buy or sell. You can find past transaction costs in a fund’s Statement of Additional Information. Index funds tend to have far fewer transaction costs than actively managed funds.
Some funds also charge Load Fees—fees paid when you buy (Front-End Load) or sell (Back-End Load) shares. A typical Front-End Load is 5.75% of the amount invested. Funds with Load Fees also tend to charge higher Expense Ratios, which go in part to pay the investment advisors who sell them.
| Fund Type | Maximum Expense Ratio | Ideal Target |
|---|---|---|
| Actively Managed | 75 basis points (0.75%) | ≤ 50 basis points |
| Index Funds | 25 basis points (0.25%) | < 10 basis points (best case: < 5 bps) |
Principle
High fees can add years—even a decade—to the time it takes you to reach Level 7 Financial Freedom. Index funds offer both low fees and better performance. Keep fees as low as possible so your money works for you, not for a fund company or advisor.
You have just four goals when deciding how to invest: Diversification—don’t put all your eggs in one basket, since nobody knows which asset class will outperform next; Equities—keep more money in stocks than bonds because stocks outperform over the long term; Low Cost—favor index funds to minimize fees; and Simplicity—keep it easy to understand and manage.
By investing in just one mutual fund, you can get great diversification, stock exposure, and low costs. If you’re 25 and plan to retire at 65, you’d choose a fund close to your retirement year (e.g., Vanguard’s 2060 fund). TDR funds handle rebalancing for you, and they automatically shift your portfolio toward bonds as you near retirement. The 2060 fund today invests about 90% in stocks and 10% in bonds; the 2020 fund invests 53% in stocks and 47% in bonds. They are by far the easiest way to invest—truly “set it and forget it.”
TDR funds have a drawback in taxable accounts: they include bond funds, which generate taxable interest if held outside a retirement account. Good TDR funds (like Vanguard’s) are relatively inexpensive but still cost more than investing directly in individual index funds. Bad TDR funds can get very expensive.
For a bit more flexibility while keeping simplicity, invest in a TDR plus one additional fund that covers an investing style important to you. For example, investor Paul Merriman recommends a TDR plus a small cap value fund. You might invest 90% in Vanguard’s 2060 fund and 10% in the Vanguard Small-Cap Value Index Fund (VISVX).
This requires three types of index funds: U.S. Stocks, Foreign Stocks, and U.S. Bonds. An 80/20 portfolio (80% stocks, 20% bonds) is ideal for long-term investors who don’t need the money for at least 10 years.
| Allocation | Fund |
|---|---|
| 50% | Vanguard Total Stock Market Index Fund (VTSAX) |
| 30% | Vanguard Total International Stock Index Fund (VTIAX) |
| 20% | Vanguard Total Bond Index Fund (VBTLX) |
For those with an adventurous spirit, this approach provides broader diversification but requires annual rebalancing.
| Allocation | Fund |
|---|---|
| 30% — U.S. Large Cap | Vanguard 500 Index Fund Admiral Shares (FVIAX) |
| 10% — U.S. Small Cap Value | Vanguard Small Cap Value Index Fund Admiral Shares (VSIAX) |
| 20% — U.S. Bonds | Vanguard Intermediate-Term Bond Index Fund Admiral Shares (VBILX) |
| 20% — Foreign Developed | Vanguard Developed Markets Index Fund Admiral Shares (VTMGX) |
| 10% — Emerging Markets | Vanguard Emerging Markets Stock Index Fund Admiral Shares (VEMAX) |
| 10% — REITs | Vanguard Real Estate Index Fund Admiral Shares (VGSLX) |
Key Insight
There is no “right” answer among these options. For those starting out, a TDR Fund inside a retirement account is a great solution. Ultimately, go with a portfolio you’ll stick to no matter how the market performs.
”Don’t simply retire from something; have something to retire to.” — Harry Emerson Fosdick
Retirement accounts fall into three primary categories: Workplace Retirement Accounts (offered by your employer, most commonly 401(k) and 403(b) plans), Individual Retirement Accounts (which you open on your own), and Health Savings Accounts (available if you have a High Deductible Health Plan).
There is an annual contribution limit (indexed to inflation). Some employers match a percentage of your contributions. The accounts come in two flavors with vastly different tax benefits:
| Feature | Traditional 401(k) | Roth 401(k) |
|---|---|---|
| Tax on contributions | Deducted from taxable income now | No deduction (tax paid now) |
| Tax on withdrawals | Taxed as ordinary income in retirement | Tax-free in retirement (including earnings) |
| Core benefit | Defers taxes for decades | Potential for decades of tax-free growth |
For most people, the Roth 401(k) is the better choice. Note that all employer matching contributions go into a Traditional 401(k) even if your contributions are to a Roth. So you’ll effectively have two accounts.
Contribution limits are lower than for a 401(k). Unlike a 401(k), contributions don’t automatically reduce your W-2 income. You must deduct them on your tax return—and you can only do so if you qualify. If you are single or head of household, you can deduct IRA contributions if you are not covered by a workplace plan, or if you are covered but your modified adjusted gross income (MAGI) falls below the phase-out threshold.
Roth IRA contributions are not deductible, so there are no complicated deductibility rules. Qualified distributions in retirement are tax-free, and you can always withdraw your contributions (not earnings) tax- and penalty-free. However, you can make too much money to contribute directly—income phase-out ranges apply.
If your income disqualifies you from a Roth IRA, you can contribute to a Traditional IRA and then convert it to a Roth IRA. Because you didn’t take a tax deduction on the contribution, the conversion doesn’t trigger tax liability (any growth between contribution and conversion would be taxable, but if you convert quickly, this is minimal).
Key Insight — The Pro-Rata Complication
The IRS treats all your Traditional IRAs as one. If you have a $5,000 deductible IRA and contribute $5,000 to a new nondeductible IRA for a Backdoor Roth conversion, the IRS will treat the conversion as $2,500 from each. The $2,500 attributed to your old deductible IRA is taxable income. Tax laws are tricky and can change—consult a tax advisor.
The tax advantages of an HSA are without equal—imagine combining the tax deductibility of a Traditional 401(k) with the tax-free withdrawals of a Roth 401(k). You get three tax advantages: contributions are tax deductible regardless of income; the account grows tax-deferred; and distributions are tax-free when used for qualified medical expenses at any age. You can also use HSA funds for nonmedical expenses, but you lose the tax-free withdrawal benefit—the distribution is taxed as ordinary income, and before age 65, there is a 20% penalty (the penalty goes away at 65).
Those in the top tax brackets may be better off with Traditional (not Roth) retirement accounts, because the higher your bracket, the more valuable the tax deductions. If you have significant medical bills and can’t max out all retirement accounts, prioritize HSA contributions—but still contribute enough to your 401(k) to get the match.
For extreme early retirees: you may need to curtail HSA contributions if your other accounts can’t fund living expenses before age 65. One strategy is to contribute to traditional retirement accounts during working years, then execute a Roth IRA Conversion Ladder once retired—converting traditional accounts to Roth while your taxable income is near $0, keeping conversions small enough to stay in a low tax bracket.
Action
Save one month of expenses before anything else—this takes priority over retirement savings. Keep your emergency fund in a high yield online savings account, separate from your checking account, to protect it from temptation.
The only tool you need is Morningstar.com. Look up any fund from your 401(k) list to learn its full name, whether it charges Load Fees, its Expense Ratio, and what index or strategy it tracks.
As a walkthrough example, a 401(k) list might include “FID 500 Index (FXAIX)“—Morningstar reveals it’s the Fidelity 500 Index Fund, with no load fees, an Expense Ratio of just 0.02%, tracking the S&P 500. Perfect for the U.S. stock component of a 3-Fund Portfolio. For bonds, “FID US BOND IDX (FXNAX)” charges just 3 basis points, no load, and invests in intermediate-term mostly U.S. bonds—the Portfolio tab confirms over 90% U.S. bonds. For international stocks, “FID INTL INDEX (FSPSX)” charges 5 basis points and invests in a blend of large foreign companies. You can follow this same process to find any fund type your 401(k) offers.
”The best time to plant a tree is twenty years ago. The second best time is now.”
If the cost of a TDR fund is above 25 basis points (0.25%), it’s too expensive—below 15 basis points is preferable. Anything above 100 basis points (1%) is highway robbery. If your company doesn’t offer affordable TDR options, evaluate the other fund choices for lower-cost index funds and build a 3-Fund Portfolio instead.
Fidelity offers several index funds at very low cost, and recently introduced some with no cost at all. However, its TDR funds are on the expensive side—if you want a TDR fund, Fidelity is not your best choice. There is no minimum investment required to open an IRA at Fidelity, but some individual mutual funds do have minimums.
Morningstar publishes two return figures for funds: Total Returns and Investor Returns. Total Returns assume you invest a lump sum at the beginning and leave it untouched. Investor Returns capture what real investors actually earned. In real life, investors tend to get excited when the market is up and scared when it’s down—they invest more when excited and withdraw when nervous. The result is almost always the same: investors underperform the fund’s Total Return because they are terrible at timing the market.
Principle
The biggest threat to your journey to Financial Freedom is you. The hard part isn’t coming up with a plan—the hard part is sticking to it.
The stock market has weathered the 1929 crash, the Great Depression, WWII, the Korean War, the Cuban Missile Crisis, Vietnam, the Oil Embargo, near-20% interest rates (1980–82), Black Monday (1987—a 22.6% single-day crash), the Dot-Com Bubble, and 9/11. We don’t know what the next crisis will be or when it will occur, but there will be one. Good years often follow bad years, and bad years often follow good years—this is normal.
Many people who sold in fear during the 2007–2009 crash (a 50%+ drop) tell their stories today with profound regret. By 2012, the market had fully recovered. Those who continued investing during those dark days were buying at low prices and reaping the benefits of the recovery.
Avoid lifestyle debt like the plague—this is debt incurred on credit cards to fund living expenses like eating out and vacations. It’s the worst possible debt because you have nothing of lasting value to show for it. Work hard to avoid car loans; if you must finance a car, get the least expensive option possible. Be smart about student debt by exploring loan forgiveness programs, repayment plans, and refinancing to lower rates. And don’t be house poor—a good rule of thumb is to spend no more than 20% of your monthly gross income on housing expenses.
Action
Never stop learning about investing and finances. Read the Wall Street Journal even once a week. Read a good book on investing, even just one a year. You don’t have to be a money geek, but don’t stick your head in the sand either.
Some investment professionals earn fees through commissions on the investments they sell you—this is the purpose of Load Fees, and the same applies to expensive products like indexed annuities. The criticism of this model is the potential for conflicts of interest: commissioned professionals have a powerful incentive to sell only investments that pay them, and will almost never recommend a low-cost index fund because they can’t earn a fee from it.
The theoretical solution is a fee-only investment advisor who charges you directly for services rather than earning commissions. However, even fee-only advisors can be expensive.
Key Insight
The best option is to handle your own investments. If you want help, you must consider the cost. Traditional commissioned and even fee-only advisors are generally too expensive for those pursuing Financial Freedom.
”Of all the things that can boost emotions, motivation, and perceptions during a workday, the single most important is making progress in meaningful work. Whether they are trying to solve a major scientific mystery or simply produce a high-quality product or service, everyday progress—even a small win—can make all the difference in how they feel and perform.”
If you are working hard to save 5% of your income, focusing on a distant goal of a 30% Saving Rate is not helpful—it may even be frustrating and discouraging, making every step feel like a failure. Rather than focusing exclusively on the big goal, create smaller, intermediate goals. Perhaps that means increasing your Saving Rate from 5% to 7% within 12 months.
Action — Small Wins
Seeing regular improvements, however small, builds confidence and encourages you to keep moving toward bigger goals. Think outside the box when it comes to small wins.
”Every time you borrow money, you’re robbing your future self.”
The first problem with debt is that financing a purchase often lulls us into spending more than we should. This is particularly true with cars and homes. You should be acutely aware of how financing is affecting your buying decision.
A home mortgage is generally considered “good” debt because homes tend to increase in value over the long term. However, this good debt can turn bad if: you pay more than the home’s value; you spend more than you can truly afford; you finance nearly all of the purchase price, leaving few options if values drop; or you buy in an area where renting is far more affordable.
Principle
As a rule of thumb, you should not borrow more than one to one-and-a-half times your expected first-year income. Consider that before you sign the loan documents.
Getting out of debt is simple—though not easy. There are four steps:
| Approach | Strategy | Rationale |
|---|---|---|
| Debt Snowball | Apply extra payments to the smallest balance first. | Creates quick wins and can improve consistency. |
| Debt Avalanche | Apply extra payments to the highest interest rate first. | Usually minimizes total interest and payoff time. |
Action
Calculate the difference between these two approaches using a free Debt Snowball Calculator before deciding which to follow.
In most cases, investing should not take a backseat to paying off debt. You should still make more than the minimum payments on your debt, but tackling debt shouldn’t come at the expense of saving and investing.
Principle — Three Priority Rules
The key is to see yourself as an investor, regardless of your age. Investing isn’t for old people. It is for anybody, at any age, who wants to take control of their money and achieve Financial Freedom. The sooner you start, the easier it is.
Principle — Working Through Objections
What if you could be just as happy with less stuff? What if you could have complete control over what made you happy and what didn’t? What if the things you thought were making you happy really weren’t—or even made life less joyful? These are questions worth sitting with as you continue your journey.
Action
For recommended books, software, and apps on everything from budgeting to investing to improving your credit, visit retirebeforemomanddad.com/resources. The page is kept updated as new tools come out.