by Introduction
Money is the unit of caring, and even small amounts of money can prevent tremendous quantities of suffering. Therefore, it's worthwhile for us to learn some basics about personal finance (to the point of diminishing returns from reading more).
I don't profess to be an expert on this topic, but I have learned bits and pieces of the puzzle over the past 7 years. I thought I would share some of the highlights of my own approach to money. Feel free to add your own insights and/or correct anything I say.
General points
First things first
Before worrying about personal-finance and tax optimizations, focus on the big picture. What career will have the highest impact? If you want to earn money to donate, where can you earn the most, taking into account your skills, working hours, lifestyle sustainability, etc.? Do you want to shoot for a startup? You can make the biggest impact to your wealth by thinking about these areas.
Spend time learning the basics of personal finance
Get an intro book or three on the subject, or browse various articles you can find online. Don't worry so much about news, but try to focus on more timeless information, e.g., from Wikipedia or other standard websites.
What I do
Here's what I do with my finances; YMMV. Also keep in mind that some of these are specific to the US.
Brokerage and checking accounts
I have a brokerage account for trading stocks. With the same company, I also have a donor-advised fund (DAF) that allows me to get tax deductions for giving now without committing to a specific 501(c)(3). (Before putting a lot of money irrevocably into a DAF, make sure that you can donate to your charity of choice through it. But in practice, you should be able to donate to almost all standard US 501(c)(3)'s without a problem.)
The rest of my bills I pay from the checking account of a local credit union. I keep in the checking account only as much as I need to pay expenses in the next month, because the interest rate on the account is near 0%.
When I earn a paycheck every half-month, I deposit some amount into my checking account. The remainder is direct-deposited to my brokerage account, from which point I either buy a new, random stock or else donate the cash to my DAF.
Buying stocks
Stocks historically have had higher expected returns than bonds. For more evidence on this point, see the discussion about the "equity premium puzzle." Even if you don't believe the equity premium is large, it seems harder to argue that it's not at least positive (see a summary table of risk-premium estimates from various studies on p. 3 of "Rethinking the Equity Risk Premium: An Overview and Some New Ideas"). And since altruists should generally be risk-neutral, it seems better to invest exclusively in equity, not in fixed-income securities, excepting special circumstances.
I pay no attention to the apparent quality of the stock that I buy; I pick something basically at random, perhaps with some bias toward high-beta stocks, though the existence of an advantage for stocks with greater systemic risk has been disputed.
When you're competing against dozens of hedge funds and investment banks with sub-second trading systems and hordes of experts who spend 70 hours a week researching companies, I don't think you should expect to gain much advantage by making a trade based on a 30-minute-old story you read in the news, or even based on your pet theory of the economy's future. Maybe capital markets aren't actually efficient, but in practical terms, there's little you can do to improve your stock selection, perhaps short of spending your life as a hedge-fund analyst.
Another criterion for stock selection may be low dividend yield. The reason is that "non-qualified" dividends are taxed at ordinary income-tax rates (e.g., 28%) on the year of the dividend, whereas capital gains are taxed at lower rates (e.g., 15% as of 2013) and not until you sell the stock. Moreover, if you donate the stock, you never pay capital-gains tax at all but actually can save money from higher capital gains. Actually, many dividends are "qualified" and so are taxed at capital-gains rates, but it's still undesirable that you have to pay these taxes earlier rather than when you dispose of the stock, or not at all if you donate it.
What about mutual funds?
Index funds with low expense ratios can be a good option. I personally prefer to buy stocks instead because there are complications you have to remember to avoid paying double taxes on mutual funds, and I would rather not have to think about that. Also, mutual funds pay dividends, and even qualified dividends will be taxed less favorably than capital gains if Congress's tax breaks expire in 2013.
As far as fees, it's possible to find index funds with expense ratios below ~0.2% per year. That's for mutual funds. For stocks purchased directly: When I make a trade through my broker, I pay an ~$8 flat fee, and to buy ~$2K worth of stock, this implies a fee of ~0.4%. But mutual-fund fees accumulate every year, while this stock-trading fee is a one-time cost, so after a few years, it's cheaper to buy the stock directly. If you also sell the stock, you might need to wait longer for this break-even point to happen, since there would be another ~$8 fee to sell it, but this isn't the case if you donate the stock. In any event, if you are going to sell rather than donate the stock, you may want to shoot for the lower five-year capital-gains rate if that makes sense in your situation. In general, it's best to hold a stock as long as possible before selling in order to push the capital-gains taxes as far into the future as possible. Paying tax on the same amount of capital gains is better more years into the future because of the time value of money now vs. later.
As with stocks, it's better to pick mutual funds with lower distributions (similar to dividend yields). Fortunately, distributions from index funds tend to be low because of minimal turnover in the underlying basket of stocks. So index funds are a win-win: Low expense ratios and low distributions at the same time.
My DAF only allows for investing in mutual funds rather than stocks, but this isn't so bad because the income-tax-deduction benefits of the DAF far outweigh the possibly higher expenses that mutual funds involve, and the tax-reporting complications of mutual funds don't apply here because the funds in the DAF aren't taxed. By the same token, dividend yields aren't a concern for mutual funds in a DAF. Finally, consistent with the point about equity vs. fixed income above, I pick mutual funds that are 100% equity.
Donating stocks
I donate to charity by depositing stocks into my DAF that have high long-term capital gains (held >1 year). See "Advice for Donors with Capital Gains" for details. If you have stocks bought through an ESPP, you may need to wait 21-24 months before these are considered "long-term" for purposes of (a) securing lower capital-gains tax rates when selling or (b) deducting the fair-market value instead of the cost basis when donating.
I modify my W4 to have a larger-than-usual number of allowances to account for the fact that I'll be getting a big tax deduction by donating to my DAF. This means I pay less in taxes now rather than getting a refund next year, since a refund is an interest-free loan to the government.
Tender offers
One annoying aspect of owning stocks directly as I do is that every so often, you'll get a letter about a "tender offer" to buy your shares for a fixed price prior to a merger. This has happened to me three tims in ~4 years of owning ~15 stocks at any given time. I'm unsure about what to do in this situation. Is it okay not to sell your shares, or does that risk having them decline in value, or at least become harder to sell if they're no longer publicly traded?
In a Yahoo Answers discussion, one reply says:
Another adds:
The last time I got a tender offer, the stock was currently selling at the same price as the tender-offer price, so I decided to get rid of the shares in the normal way without bothering with the paperwork of the offer itself. In particular, I just donated the shares to my DAF in order to avoid the hassle of having capital gains on my tax return.
Note that "mini-tender offers" are much less well regulated than tender offers, and general advice is to avoid taking them.
Employer matching
I take full advantage of the ESPP that my company offers. Because I don't care much about risk, it doesn't bother me to hold a lot of stock in one company, although I do donate it after the 2-year time limit passes.
I also take full advantage of my employer's "matching contributions" program, which doubles the value of my donation to any 501(c)(3) public charity in the US up to $12K per year.
In addition, my employer matches every $1 I put in my 401(k) with an additional $0.50 contribution up to 6% of pay. I max out this matching because the free money is too good to pass up. However, I don't do any additional retirement savings, nor do I have an IRA, because it seems like there's a decent risk (>20%?) that the financial system as we know it will have changed radically within 40 years. In any event, 40 years is a long time to forgo the potentially greater compound returns from charitable activities. And even if you think you'd rather invest than donate now, you might change your mind; but once money is in a 401(k), it's hard/expensive to retrieve. Finally, I'm not so worried about having savings to support myself, because by the time I'm no longer able to work, either I'll continue to be providing utilitarian value, in which case someone might fund me, or else I won't be providing value, in which case it doesn't really matter what happens.
Note: I've recently changed my thoughts on 401(k) plans -- see this Felicifia post for details. In particular, if you expect to retire early or transition from a high-earning job to a low-income job, then contributing to a 401(k) could be a good idea in order to avoid capital-gains taxes and reduce your income while you're in a higher marginal bracket. If you expect to earn a lot and donate a lot indefinitely, then contributing more than what your employer will match to a 401(k) probably still doesn't make sense.
Tax deductions
I do my own taxes using TurboTax, and one reason is that I like to learn how taxes are computed in order to naturally find out about opportunities for deductions. (The other reason is that I'm a geek.
)
Take a look at Wikipedia's list of itemized deductions to get a quick sense of what things might be relevant, and if you have any of those, put records of them in a place where they won't get lost. I track my charitable donations using ItsDeductible, which can be automatically imported into TurboTax.
Get started on your taxes early in case complications arise that take more time than you expected, as well as to get your refund earlier. (That said, if you expect to owe money on your tax return, it makes sense to wait as long as possible.)
Credit card
I use a credit card with a 1% cash back that also includes 5% cash back on selected categories each quarter of the year. I use this to pay all bills that can be paid with a credit card, both because of the cash back and because this gives me a one-month interest-free loan on paying those bills.
About half of my credit-card expenditures go toward groceries, and groceries are one of the special cash-back categories during one quarter of the year. So on average, my cash back is 1% for every purchase plus an additional 4% for about (1/4)*(1/2) of purchases, or ~1.5%. In addition, the interest-free loan on purchases lasts between 1 and 2 months (say 6 weeks on average). Assuming, e.g., an 8% discount rate and simple interest, delaying repayment for 6 weeks is worth (6/52)*(8%) = 0.9% returns. So overall, purchases with my credit card save ~1.5 + ~0.9 = ~2.4% over purchases with cash or a debit card. If I spend, say, $8,000 per year on purchases, I save ~$190 per year through cash back and delayed repayment.
Saving on spending
A penny saved is a penny earned[*], so I also think about ways to spend less. I live within walking distance of my workplace, so I don't own a car and don't have to buy gas or vehicle insurance. I buy big bags of beans from Safeway to help reduce food expenses. I buy all of my clothes at Goodwill. My main expenditures consist of (in descending order) rent, food, Internet, electricity, water/sewer, and occasionally other random purchases, like sneakers or my computer monitor or my treadmill.
[*] Correction: Because of income tax, a penny saved is more than a penny earned, unless you can fully deduct the earned pennies.
Will and beneficiaries
I found a lawyer to write me a simple will that leaves all of my assets to charity. This is important, because by default, if I were to die, my assets would go to my family. Even at my age, the average male probability of death is about 0.15% per year. I sent copies of my will to my family and a friend, and I have a copy in my cupboard.
My 401(k) account, brokerage account, and employer-sponsored life insurance have beneficiary designations, and these need to be updated as well. I was able to designate my DAF as the beneficiary for my brokerage account. My DAF, in turn, has a section where I can designate the default charities to which the money would go if I didn't donate it all on my own.
My 401(k) account can't designate the DAF, so I'm looking into how to set the beneficiary to be a specific charity instead.
Money is the unit of caring, and even small amounts of money can prevent tremendous quantities of suffering. Therefore, it's worthwhile for us to learn some basics about personal finance (to the point of diminishing returns from reading more).
I don't profess to be an expert on this topic, but I have learned bits and pieces of the puzzle over the past 7 years. I thought I would share some of the highlights of my own approach to money. Feel free to add your own insights and/or correct anything I say.
General points
First things first
Before worrying about personal-finance and tax optimizations, focus on the big picture. What career will have the highest impact? If you want to earn money to donate, where can you earn the most, taking into account your skills, working hours, lifestyle sustainability, etc.? Do you want to shoot for a startup? You can make the biggest impact to your wealth by thinking about these areas.
Spend time learning the basics of personal finance
Get an intro book or three on the subject, or browse various articles you can find online. Don't worry so much about news, but try to focus on more timeless information, e.g., from Wikipedia or other standard websites.
What I do
Here's what I do with my finances; YMMV. Also keep in mind that some of these are specific to the US.
Brokerage and checking accounts
I have a brokerage account for trading stocks. With the same company, I also have a donor-advised fund (DAF) that allows me to get tax deductions for giving now without committing to a specific 501(c)(3). (Before putting a lot of money irrevocably into a DAF, make sure that you can donate to your charity of choice through it. But in practice, you should be able to donate to almost all standard US 501(c)(3)'s without a problem.)
The rest of my bills I pay from the checking account of a local credit union. I keep in the checking account only as much as I need to pay expenses in the next month, because the interest rate on the account is near 0%.
When I earn a paycheck every half-month, I deposit some amount into my checking account. The remainder is direct-deposited to my brokerage account, from which point I either buy a new, random stock or else donate the cash to my DAF.
Buying stocks
Stocks historically have had higher expected returns than bonds. For more evidence on this point, see the discussion about the "equity premium puzzle." Even if you don't believe the equity premium is large, it seems harder to argue that it's not at least positive (see a summary table of risk-premium estimates from various studies on p. 3 of "Rethinking the Equity Risk Premium: An Overview and Some New Ideas"). And since altruists should generally be risk-neutral, it seems better to invest exclusively in equity, not in fixed-income securities, excepting special circumstances.
I pay no attention to the apparent quality of the stock that I buy; I pick something basically at random, perhaps with some bias toward high-beta stocks, though the existence of an advantage for stocks with greater systemic risk has been disputed.
When you're competing against dozens of hedge funds and investment banks with sub-second trading systems and hordes of experts who spend 70 hours a week researching companies, I don't think you should expect to gain much advantage by making a trade based on a 30-minute-old story you read in the news, or even based on your pet theory of the economy's future. Maybe capital markets aren't actually efficient, but in practical terms, there's little you can do to improve your stock selection, perhaps short of spending your life as a hedge-fund analyst.
Another criterion for stock selection may be low dividend yield. The reason is that "non-qualified" dividends are taxed at ordinary income-tax rates (e.g., 28%) on the year of the dividend, whereas capital gains are taxed at lower rates (e.g., 15% as of 2013) and not until you sell the stock. Moreover, if you donate the stock, you never pay capital-gains tax at all but actually can save money from higher capital gains. Actually, many dividends are "qualified" and so are taxed at capital-gains rates, but it's still undesirable that you have to pay these taxes earlier rather than when you dispose of the stock, or not at all if you donate it.
What about mutual funds?
Index funds with low expense ratios can be a good option. I personally prefer to buy stocks instead because there are complications you have to remember to avoid paying double taxes on mutual funds, and I would rather not have to think about that. Also, mutual funds pay dividends, and even qualified dividends will be taxed less favorably than capital gains if Congress's tax breaks expire in 2013.
As far as fees, it's possible to find index funds with expense ratios below ~0.2% per year. That's for mutual funds. For stocks purchased directly: When I make a trade through my broker, I pay an ~$8 flat fee, and to buy ~$2K worth of stock, this implies a fee of ~0.4%. But mutual-fund fees accumulate every year, while this stock-trading fee is a one-time cost, so after a few years, it's cheaper to buy the stock directly. If you also sell the stock, you might need to wait longer for this break-even point to happen, since there would be another ~$8 fee to sell it, but this isn't the case if you donate the stock. In any event, if you are going to sell rather than donate the stock, you may want to shoot for the lower five-year capital-gains rate if that makes sense in your situation. In general, it's best to hold a stock as long as possible before selling in order to push the capital-gains taxes as far into the future as possible. Paying tax on the same amount of capital gains is better more years into the future because of the time value of money now vs. later.
As with stocks, it's better to pick mutual funds with lower distributions (similar to dividend yields). Fortunately, distributions from index funds tend to be low because of minimal turnover in the underlying basket of stocks. So index funds are a win-win: Low expense ratios and low distributions at the same time.
My DAF only allows for investing in mutual funds rather than stocks, but this isn't so bad because the income-tax-deduction benefits of the DAF far outweigh the possibly higher expenses that mutual funds involve, and the tax-reporting complications of mutual funds don't apply here because the funds in the DAF aren't taxed. By the same token, dividend yields aren't a concern for mutual funds in a DAF. Finally, consistent with the point about equity vs. fixed income above, I pick mutual funds that are 100% equity.
Donating stocks
I donate to charity by depositing stocks into my DAF that have high long-term capital gains (held >1 year). See "Advice for Donors with Capital Gains" for details. If you have stocks bought through an ESPP, you may need to wait 21-24 months before these are considered "long-term" for purposes of (a) securing lower capital-gains tax rates when selling or (b) deducting the fair-market value instead of the cost basis when donating.
I modify my W4 to have a larger-than-usual number of allowances to account for the fact that I'll be getting a big tax deduction by donating to my DAF. This means I pay less in taxes now rather than getting a refund next year, since a refund is an interest-free loan to the government.
Tender offers
One annoying aspect of owning stocks directly as I do is that every so often, you'll get a letter about a "tender offer" to buy your shares for a fixed price prior to a merger. This has happened to me three tims in ~4 years of owning ~15 stocks at any given time. I'm unsure about what to do in this situation. Is it okay not to sell your shares, or does that risk having them decline in value, or at least become harder to sell if they're no longer publicly traded?
In a Yahoo Answers discussion, one reply says:
Take the recent example of Pipex. Another company took over the bulk of Pipex and in payment made a tender offer of 10-11p for 58% of shareholdings. If you didn,t tender then you retained all of your shares, which dropped to acouple of pence, I think. They are know called Freedom4 and price about 2p.
Another adds:
Often there is a secondary tender offer if the deal goes through. If you miss that, you may end up with something that is very hard to trade (not listed on exchanges).
The last time I got a tender offer, the stock was currently selling at the same price as the tender-offer price, so I decided to get rid of the shares in the normal way without bothering with the paperwork of the offer itself. In particular, I just donated the shares to my DAF in order to avoid the hassle of having capital gains on my tax return.
Note that "mini-tender offers" are much less well regulated than tender offers, and general advice is to avoid taking them.
Employer matching
I take full advantage of the ESPP that my company offers. Because I don't care much about risk, it doesn't bother me to hold a lot of stock in one company, although I do donate it after the 2-year time limit passes.
I also take full advantage of my employer's "matching contributions" program, which doubles the value of my donation to any 501(c)(3) public charity in the US up to $12K per year.
In addition, my employer matches every $1 I put in my 401(k) with an additional $0.50 contribution up to 6% of pay. I max out this matching because the free money is too good to pass up. However, I don't do any additional retirement savings, nor do I have an IRA, because it seems like there's a decent risk (>20%?) that the financial system as we know it will have changed radically within 40 years. In any event, 40 years is a long time to forgo the potentially greater compound returns from charitable activities. And even if you think you'd rather invest than donate now, you might change your mind; but once money is in a 401(k), it's hard/expensive to retrieve. Finally, I'm not so worried about having savings to support myself, because by the time I'm no longer able to work, either I'll continue to be providing utilitarian value, in which case someone might fund me, or else I won't be providing value, in which case it doesn't really matter what happens.
Note: I've recently changed my thoughts on 401(k) plans -- see this Felicifia post for details. In particular, if you expect to retire early or transition from a high-earning job to a low-income job, then contributing to a 401(k) could be a good idea in order to avoid capital-gains taxes and reduce your income while you're in a higher marginal bracket. If you expect to earn a lot and donate a lot indefinitely, then contributing more than what your employer will match to a 401(k) probably still doesn't make sense.
Tax deductions
I do my own taxes using TurboTax, and one reason is that I like to learn how taxes are computed in order to naturally find out about opportunities for deductions. (The other reason is that I'm a geek.
)Take a look at Wikipedia's list of itemized deductions to get a quick sense of what things might be relevant, and if you have any of those, put records of them in a place where they won't get lost. I track my charitable donations using ItsDeductible, which can be automatically imported into TurboTax.
Get started on your taxes early in case complications arise that take more time than you expected, as well as to get your refund earlier. (That said, if you expect to owe money on your tax return, it makes sense to wait as long as possible.)
Credit card
I use a credit card with a 1% cash back that also includes 5% cash back on selected categories each quarter of the year. I use this to pay all bills that can be paid with a credit card, both because of the cash back and because this gives me a one-month interest-free loan on paying those bills.
About half of my credit-card expenditures go toward groceries, and groceries are one of the special cash-back categories during one quarter of the year. So on average, my cash back is 1% for every purchase plus an additional 4% for about (1/4)*(1/2) of purchases, or ~1.5%. In addition, the interest-free loan on purchases lasts between 1 and 2 months (say 6 weeks on average). Assuming, e.g., an 8% discount rate and simple interest, delaying repayment for 6 weeks is worth (6/52)*(8%) = 0.9% returns. So overall, purchases with my credit card save ~1.5 + ~0.9 = ~2.4% over purchases with cash or a debit card. If I spend, say, $8,000 per year on purchases, I save ~$190 per year through cash back and delayed repayment.
Saving on spending
A penny saved is a penny earned[*], so I also think about ways to spend less. I live within walking distance of my workplace, so I don't own a car and don't have to buy gas or vehicle insurance. I buy big bags of beans from Safeway to help reduce food expenses. I buy all of my clothes at Goodwill. My main expenditures consist of (in descending order) rent, food, Internet, electricity, water/sewer, and occasionally other random purchases, like sneakers or my computer monitor or my treadmill.
[*] Correction: Because of income tax, a penny saved is more than a penny earned, unless you can fully deduct the earned pennies.
Will and beneficiaries
I found a lawyer to write me a simple will that leaves all of my assets to charity. This is important, because by default, if I were to die, my assets would go to my family. Even at my age, the average male probability of death is about 0.15% per year. I sent copies of my will to my family and a friend, and I have a copy in my cupboard.
My 401(k) account, brokerage account, and employer-sponsored life insurance have beneficiary designations, and these need to be updated as well. I was able to designate my DAF as the beneficiary for my brokerage account. My DAF, in turn, has a section where I can designate the default charities to which the money would go if I didn't donate it all on my own.
My 401(k) account can't designate the DAF, so I'm looking into how to set the beneficiary to be a specific charity instead.
