If you’re at all familiar with The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, you’re probably aware that the authors found a disproportionate number of millionaires clustered in middle-class and blue-collar neighborhoods and not in the more affluent or white-collar communities.
The reason? High-income white-collar professionals were more likely to allocate income to consumption items and to forgo savings and investments.
Lawyers fit firmly into what the authors described as UAWs (Under Accumulators of Wealth), which is particularly troublesome given the advantage of having a higher income than the nation’s average.
If you’re a young lawyer just starting out (or an older lawyer taking a fresh look at your finances), what steps can you take to accumulate wealth and build a solid financial future?
Getting Started
The first step is simply to get started.
A recent study showed that at companies with voluntary 401(k) enrollment, only 59% of employees participated in 401(k) plans. At companies where enrollment is automatic and employees must “opt-out,” participation is at a staggering 86%.
This tells us that the default option (inertia) is a powerful force. If you want to harness it, simply open these retirement accounts today and start with the lowest contribution amount possible.
Before you know it, maxing out your retirement accounts will be the default option and you won’t notice the difference.
The second step is to leave your investments alone.
Back in 2014, Fidelity reportedly conducted an internal review of accounts that concluded that those who had either forgot they had an account, or who were dead, performed the best out of all investors.
Whether the story is true or not, the principle is sound. Simply allowing your investments time to compound and grow will likely lead to a better performing portfolio than that of the investor who is constantly tweaking holdings. Most of the good investment advice out there is simply trying to save the investor from himself or herself.
What About Student Loan Debt?
A lot of you are thinking that you’d love to save for retirement, but you’ve got this small problem of $200,000 in student loan debt following you around like an unwelcome house guest.
With student loans, you really only have two options: pay them back or pursue forgiveness. Neither is a particularly quick solution, and there’s no magic wand that will make the process less painful. Having paid off $190,000 myself, I can confirm that paying off student loans is a slog.
However, if you’ve decided to pay back your loans, you can refinance them to cut the interest rate, sometimes as much as by half. I graduated when no such refinancing existed. You’re in a much better position, since the student loan refinance market is hot with competition, ensuring you’ll get a lower rate. Of course refinancing your student loans doesn’t mean that you’ve actually done anything about repaying them. You can only do that one payment at a time.
Many lawyers have yet to refinance their loans because they’re worried they may not be able to make payments in the future, and want the option to return to an income-driven repayment plan like IBR or REPAYE “just in case”. If you’re paying an extra $7,000 a year in interest for this privilege, you should understand that this is a very expensive insurance policy premium. Like all other unsecured debt, the student loan companies can’t repossess assets (i.e. your brain) in the event you stop making payments. Is the risk really worth the price of the extra interest?
While paying back those loans, it still makes sense to contribute to retirement accounts if you can. The tax savings that you get when contributing to retirement accounts are too great to ignore.
Retirement Accounts: How to Save Money on Taxes
A lot of lawyers quickly recognize that their single greatest expense each year isn’t a mortgage or rent payment. Instead, it’s the annual tax bill.
This leads to a natural question: What can I do to legally reduce my tax burden?
The government incentivizes you to take certain actions and rewards you when you do so. So, if you’re looking to save some money on your tax bill, you might as well do what the government wants you to do.
Three types of accounts could allow a single person to shelter up to $26,900 of income each year: (1) 401(k); (2) Roth IRA; and (3) Health Savings Account.
The 401(k) is the standard “go to” retirement account. Employees can contribute up to $18,000 to a 401(k) account annually in 2017. This is money that comes straight off the top of your income, allowing you to save on your federal taxes at your marginal tax rate. For many lawyers, this could be a tax savings of 33% or more. The money in your 401(k) will grow tax-free, and will be taxed at ordinary income rates upon withdrawal. If during retirement you’ve moved from the big city to a warm and sunny climate (e.g. NYC to Florida), you may never pay state income tax on that money again. Regardless, your effective tax rate in retirement is likely to be significantly lower than your marginal tax rate today. Take advantage of this tax arbitrage.
Once you’ve maxed out your 401(k), lawyers can contribute $5,500 each year to a Roth IRA. Roth contributions are made with after-tax dollars. Roth accounts will grow tax-free and – unlike your pre-tax retirement accounts – will never be taxed again. Many lawyers may not be eligible to make a direct Roth IRA contribution due to income limits, but will be able to do so via a contribution through the “backdoor.” Having access to both pre-tax and post-tax money in retirement will allow you set your own tax rate through tax diversification.
The third type of retirement account is available if you have a high-deductible health insurance plan. The Health Savings Account allows an individual to contribute up to $3,400 of pre-tax money each year. This account has the particular benefit of being triple tax free. The money isn’t taxed when you contribute, while it grows or when it’s withdrawn, as long as the money is used for qualified health expenses.
Given that this is a Health Savings Account, you may be wondering how it doubles as a retirement account. First, funds roll over year-to-year, so there’s no worrying about using funds up by the end of each calendar year. Second, if you don’t use the money in the account for health expenses, you can withdraw funds after age 65 without penalty (you’ll only pay income taxes on the withdrawal). So even if you don’t have health expenses as you age (a good problem to have), the account doubles as a Traditional IRA. This is why many people call the Health Savings Account a Stealth IRA.
Do-It-Yourself Investing
Once you have money that’s being set aside in retirement accounts, at some point you’ll want to make sure you’re investing it correctly.
You don’t have to be an expert in investing or know the tax code like the back of your hand to begin building wealth.
The financial services industry would like you to believe that investing is complicated, and of course, they’ll gladly help you manage your investments for a “small” fee.
But do-it-yourself investing is well within the reach of any lawyer. Almost any low-fee equity index fund will do. Index funds, like Vanguard’s Total Stock Market Index Fund, invest in the entire stock market. It’s hard to get more diversified than owning a slice of every public company in America. When you invest in an index fund, you’re guaranteed to get close to the market return. Getting the market return is a fantastic way to build wealth, much like consistently hitting singles in a baseball game will yield more runs than swinging for the homerun each time.
From there, you simply need to determine the appropriate allocation between stocks and bonds based on your risk tolerance. Here’s a risk tolerance calculator where you can get a feel for what allocation could be appropriate for you.
Many young lawyers will pick allocations as aggressive as an 80/20 split between equity and bonds. If time is on your side and you’re putting away money you won’t need for decades, equities are a consistent performer that will power your portfolio forward.
If you’re just getting started and you don’t want to think about asset allocation, pick a low-fee (i.e. under 0.50% expense ratio) target retirement fund ending in a date like 2050. The target retirement fund will set an allocation for you. After you’ve built up some significant savings, you can re-evaluate what to do next.
Limit Lifestyle Inflation
It’s hard to both pay off your loans and save money when there’s not enough dollars to go around. And while building wealth is simply spending less than you earn and investing the difference, it’s clearly not easy.
Yet, if you do this consistently over time you’re virtually guaranteed to build wealth.
Conventional wisdom for quite a while has been that you need to drop your latte-a-day habit so that you save $5 every day instead. We’ve known this for decades, but people clearly aren’t following the advice. If they were, we’d stop seeing articles telling people to stop drinking lattes!
The truth of the matter is that when it comes to lifestyle inflation, it’s very difficult to move in one direction: backwards. You can make this easier on yourself by trying to limit lifestyle inflation in the first place since you’re unlikely to miss something you never had.
Since most of personal finance is really about human psychology, one trick you can use to limit lifestyle inflation is to pick a certain salary and stick with it. Your monthly take home “number” will differ dramatically based on family size, age, location and other factors. Regardless, if you can devise a plan to live on that “number” starting today, you can bank all future raises. Make this automatic by splitting your paycheck in two and have your payroll department direct deposit your “number” into your main checking account and “everything else” to a brokerage or savings account.
Continuing Financial Education
Treat your ongoing financial education with the importance it deserves and make sure you’re earning a few CFE (Continuing Financial Education) credits each year.
Since CFEs aren’t a real thing, how do you get them?
Pick up one or two books a year. Read a blog. Listen to a podcast.
You don’t have to read a treatise on taxes (although that’d be a good idea too), but can find plenty of good general-purpose financial books, such as The Simple Path to Wealth by JL Collins, that will help internalize the concepts. If several hundred pages is too much to start with, William J. Bernstein wrote a primer for millennials that’s only 16 pages long, which you can download for free: If You Can.
The important part is to keep exposing yourself to the basics and to make sure you’ve got the right systems set up. If you do, you’ve got a good chance of eventually becoming the millionaire lawyer next door.
About the Author
Joshua Holt is an associate with Goodwin Procter LLP and the founder of The BigLaw Investor, a blog about personal finance for lawyers. Contact Joshua on Twitter @biglawinvestor.