What if the U.S. Government Defaults?

00:00:00.000 | (beeping)

00:00:02.160 | - Welcome back to Ask the Compound.

00:00:15.420 | Excuse me.

00:00:16.520 | The S&P 500 is still in a 13% drawdown

00:00:18.780 | from all time highs.

00:00:19.620 | Duncan, on this show we are at a new

00:00:21.120 | all time high in questions.

00:00:22.320 | I swear.

00:00:23.160 | The inbox is just overflowing.

00:00:25.520 | The Google Doc, remember if you have a question,

00:00:27.040 | askthecompoundshow@gmail.com.

00:00:29.480 | - No one took us up on the video or audio question.

00:00:32.320 | - Nah, it's gonna happen though.

00:00:33.380 | Someone's gonna do it.

00:00:34.200 | Yeah, send us a video.

00:00:35.040 | We'll show it right here on YouTube.

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00:01:22.080 | All right.

00:01:22.920 | The main line of questions this week was debt default,

00:01:27.380 | debt ceiling, these kind of things.

00:01:28.720 | So let's get into some of those

00:01:29.600 | because this is where people are thinking.

00:01:32.380 | Some people are saying, "I don't care."

00:01:33.680 | Other people are saying, "I'm worried."

00:01:34.580 | So let's get into it.

00:01:35.420 | Let's do it.

00:01:36.460 | - Okay, let's do it.

00:01:37.480 | So up first today, we have a question from Aaron.

00:01:42.240 | And Aaron writes, "I've recently shifted

00:01:46.820 | "a substantial portion of the cash portion of my savings

00:01:49.360 | "into three to four month T-bills

00:01:51.400 | "to take advantage of higher yields

00:01:53.040 | "and state tax advantages.

00:01:54.680 | "As of today, they are all set to mature

00:01:56.640 | "in June and July.

00:01:58.200 | "I know a U.S. debt default is highly unlikely,

00:02:00.820 | "but the risk-averse part of me

00:02:02.180 | "is still a little nervous about what would happen

00:02:04.120 | "if Congress actually lets the unthinkable happen.

00:02:07.420 | "Are my worries misplaced?

00:02:09.280 | "What would happen to my treasury investments

00:02:11.020 | "if a default did happen?"

00:02:12.840 | So this is the big question.

00:02:14.400 | And yeah, this is what people are kind of

00:02:16.020 | starting to freak out about

00:02:16.860 | because this date is coming up very quickly.

00:02:18.700 | So what are your thoughts?

00:02:19.540 | - Yeah, this is the right area

00:02:20.880 | because there hasn't really been

00:02:21.720 | a whole lot of market volatility.

00:02:23.080 | The market didn't really fall that much.

00:02:24.680 | And now that we've had a few good headlines

00:02:26.180 | the last couple of days,

00:02:27.020 | the market has taken off a little bit.

00:02:27.880 | But this is the one area of the bond market

00:02:31.080 | or any financial market that has seen some movement,

00:02:33.360 | which is treasury bills.

00:02:34.200 | So John, give me a chart of one-month T-bill rates

00:02:37.080 | versus three-month T-bill rates.

00:02:38.960 | And what you can see with the one month is

00:02:40.840 | at the beginning of April,

00:02:41.760 | yields were like 4.75%.

00:02:43.960 | Three weeks later, they dropped like a rock,

00:02:46.000 | down to 3.3%.

00:02:48.200 | Since then, they've taken off like a rocket ship

00:02:49.960 | and going from 3.3 to 5.6 in less than a month.

00:02:53.600 | And you can see comparing to the three-month T-bill,

00:02:55.480 | which is the purple line there,

00:02:57.020 | three-month T-bills have been above one-month T-bills

00:02:59.040 | ever since this rate hiking cycle began.

00:03:01.520 | Now one-month T-bills have shot up

00:03:03.140 | above three-month T-bills

00:03:04.160 | and you're seeing a ton of volatility there.

00:03:06.300 | And so what's going on here?

00:03:09.260 | I think this is just bond traders positioning

00:03:11.460 | for this exact thing that Aaron's talking about.

00:03:13.700 | Like what if my short-term T-bills happen to mature

00:03:17.540 | right when this stuff is going on

00:03:19.020 | and maybe I miss a payment or something, right?

00:03:21.500 | So I think one of the reasons

00:03:23.700 | that the rates crashed in the first place

00:03:25.520 | is because people were buying them to get ahead of this

00:03:29.240 | and then now they've been selling them

00:03:30.360 | and the rates have taken off.

00:03:31.400 | So obviously the biggest worry here

00:03:33.680 | is that both sides don't come to an agreement.

00:03:36.200 | I think, I really hate the debt ceiling stuff.

00:03:39.040 | I mean, we can print our own currency.

00:03:40.880 | And so the people that compare

00:03:42.720 | the U.S. government to a household,

00:03:44.400 | like listen, it's just, it's apples to Mars.

00:03:47.720 | It's not on the same planet

00:03:49.200 | because the U.S. government has the ability

00:03:50.760 | to print their own currency.

00:03:51.760 | So the fact that we put this arbitrary debt ceiling limit

00:03:54.480 | makes zero sense to me.

00:03:55.880 | It's all political posturing.

00:03:57.700 | I'm not a fan of it.

00:03:58.700 | It's a crisis that is totally unnecessary,

00:04:02.160 | but politicians use it to try to get some negotiating power

00:04:05.880 | or leverage or just show that they have some power,

00:04:07.900 | I suppose.

00:04:08.800 | And so there's always the possibility

00:04:10.600 | that we don't come to an agreement.

00:04:12.360 | I do think that even if there's no agreement in place,

00:04:15.960 | I would be shocked if we missed a debt payment.

00:04:19.520 | Colin Roche, who's been a two-time guest on this show,

00:04:21.960 | had good take on this recently.

00:04:23.080 | He said, "I don't even think you get to a crisis scenario

00:04:26.200 | "because the Treasury, President, and Fed

00:04:27.680 | "have tools to work around this,

00:04:28.740 | "and I think they'd be obligated to use those tools.

00:04:30.480 | "For instance, let's say we get to May 31st

00:04:32.560 | "and the Treasury announces it has no money on June 1st.

00:04:34.880 | "Meanwhile, Congress can't agree on anything.

00:04:36.360 | "In this case, the President is forced

00:04:37.600 | "to invoke the 14th Amendment

00:04:39.400 | "to uphold the full faith and credit of the USA.

00:04:41.900 | "Once we're on the verge of defaulting,

00:04:43.220 | "we're breaching the 14th Amendment,

00:04:44.400 | "which states that it's illegal to default

00:04:45.840 | "so we could do some sort of premium bonds

00:04:48.960 | "or coin seniorage or selling Treasury assets

00:04:51.260 | "or the Fed invoking some crazy circumstances

00:04:53.340 | "where they do something."

00:04:54.920 | So, there are contingencies and plans on the table.

00:04:58.760 | Trust me on this.

00:05:00.440 | So, if a crisis, my whole thinking is,

00:05:03.480 | if a crisis is on the table and we can avert it,

00:05:05.840 | we probably will.

00:05:07.060 | Calmer, cooler heads will prevail.

00:05:09.360 | But I think if it really worries you that much,

00:05:12.320 | extend your time horizon out to six or 12-month TPLs,

00:05:14.760 | the yields aren't really that much worse.

00:05:17.560 | So, I think that's if you're really,

00:05:20.400 | so, I don't know, I guess worst-worst-case scenario,

00:05:24.000 | your payment's delayed by a couple days or a week

00:05:26.400 | if we really got bad.

00:05:27.980 | But I can't see a situation where this kind of thing

00:05:31.080 | doesn't get resolved in like 48 hours

00:05:32.720 | if it came to an ultimate crisis situation.

00:05:36.000 | - Yeah, I was reading about this before the show

00:05:38.560 | and it's interesting.

00:05:39.760 | It's a bipartisan thing, though, right?

00:05:42.000 | Typically, the debt ceiling has been raised historically

00:05:45.800 | over and over and over again.

00:05:46.960 | I can't remember how many times,

00:05:48.040 | but a lot of times in the last 50 years.

00:05:50.160 | - We should just get rid of it.

00:05:52.240 | It makes no sense to have in place

00:05:54.120 | with the way that our system is structured.

00:05:55.800 | It's just a way for politicians to feel important.

00:05:58.800 | That's kind of where I fall in.

00:05:59.640 | - You know what was kind of tripping me up

00:06:01.040 | is I was like Zach Galifianakis thinking about this.

00:06:05.640 | So, the Fed keeps raising rates,

00:06:07.720 | so it's making the U.S. government

00:06:09.800 | have to pay more on this crazy debt, right?

00:06:13.560 | - Yes.

00:06:14.400 | - So, it's like a loop of making things worse in that regard.

00:06:18.960 | - A little bit, yeah.

00:06:19.800 | Interest expense is much higher.

00:06:20.880 | I got a chart for that for Animal Spirits next week.

00:06:22.500 | So, again, we have a lot of questions of the debt ceiling,

00:06:24.280 | so let's do another one.

00:06:25.600 | We got another one of those.

00:06:26.640 | - Okay, up next, we have a question from Matt.

00:06:28.940 | "We are mid-30s.

00:06:31.080 | "Kiddo is two years old.

00:06:32.440 | "Kids are expensive, so we have to leave the city.

00:06:35.240 | "Looking to buy a house in the next year or so.

00:06:37.840 | "How do we slowly sell out of our brokerage accounts

00:06:39.800 | "so that we aren't at the whims of the market

00:06:41.760 | "if it crashes during the debt ceiling situation?

00:06:44.880 | "I'm worried the market might tank

00:06:46.160 | "and we would be forced to wait

00:06:47.160 | "until the market rebounds to buy.

00:06:48.700 | "However, selling and paying the taxes next year

00:06:51.020 | "won't be fun either,

00:06:52.240 | "plus all the other expenses that come with moving."

00:06:54.920 | - You know, last week we talked about

00:06:56.320 | moving somewhere cheaper, right?

00:06:58.280 | This person's doing just that, which is great.

00:07:01.520 | At face value, this sounds like a debt ceiling question.

00:07:04.720 | It's not.

00:07:05.540 | This is not a debt ceiling question.

00:07:06.840 | This is an asset allocation,

00:07:08.440 | risk profile, and time horizon question.

00:07:10.960 | Listen, everyone has a different appetite for risk, right?

00:07:14.160 | People who take more risk than you,

00:07:15.320 | you think that they're just irresponsible.

00:07:16.920 | People who take less risk than you

00:07:18.200 | think they're just being wimps, right?

00:07:19.560 | This is kind of how it goes,

00:07:20.560 | but I invest heavily in equities as a long-term investor,

00:07:24.480 | right?

00:07:25.320 | I have a very high tolerance for risk

00:07:26.200 | when it comes to assets that are five, 10, 15, 20 years

00:07:29.760 | into the future.

00:07:30.600 | Maybe not as high as you, Duncan.

00:07:31.480 | I'm not in the levered stuff or oat milk penny stocks.

00:07:36.480 | I don't know.

00:07:37.480 | - We're not technically a penny stock yet.

00:07:39.000 | - Okay, not yet.

00:07:40.000 | We're getting there.

00:07:42.240 | But when it comes to short and intermediate term goals,

00:07:44.040 | I'm extremely risk averse.

00:07:45.660 | So if I need money next year for a house down payment

00:07:48.040 | or a vacation or anything,

00:07:49.100 | there's no way in hell that I'm going to be,

00:07:51.240 | have that money invested in the stock market.

00:07:52.960 | No, thank you.

00:07:53.800 | The downside far outweighs the upside.

00:07:56.200 | And that downside could come from anything.

00:07:57.660 | It could be debt ceiling drama, recession, flash crash,

00:08:00.440 | the Fed, inflation, anything else

00:08:02.140 | that we're not even thinking about right now.

00:08:03.560 | So John, do a chart on of the rolling one-year returns

00:08:06.940 | for the S&P 500.

00:08:08.420 | I got this 1926 to 1923.

00:08:12.840 | Do I not have this?

00:08:14.240 | Okay.

00:08:15.200 | Maybe I didn't put this in.

00:08:16.400 | So what it looks like is on average,

00:08:18.280 | the stock market has been up 75% of the time

00:08:20.480 | on a one-year basis.

00:08:21.700 | By the way, that's not John's fault.

00:08:23.040 | I think I forgot to put it in the doc.

00:08:23.880 | - Yeah, I was about to say,

00:08:24.720 | I don't see it in the doc, to be fair.

00:08:26.480 | - That's on me.

00:08:27.320 | Whoops.

00:08:29.280 | Anyway, the point is on a rolling one-year basis,

00:08:32.540 | I went back to 1926.

00:08:33.720 | 75% of the time, the S&P 500 has been up on a rolling.

00:08:37.580 | Like, that's a pretty good hit rate, right?

00:08:38.820 | If you're going to the casino, those odds are great.

00:08:40.820 | But a one in four chance of loss

00:08:42.840 | is not a great probability when it comes

00:08:44.500 | to something as important as a house down payment.

00:08:45.880 | Plus, when stocks were down those one out every four years,

00:08:48.980 | on average, they were down 10% or worse

00:08:50.780 | more than 52% of the time.

00:08:52.740 | They were down 20% or worse 25% of the time.

00:08:55.460 | They were down 30% or worse 12% of the time.

00:08:57.660 | So I think this person is worried

00:09:00.220 | about the wrong things here.

00:09:01.060 | We're not worried about debt ceiling

00:09:02.380 | or tax payments, any of that stuff.

00:09:03.920 | That stuff's not fun to go through,

00:09:05.040 | but you should be worrying about your housing fund

00:09:06.960 | losing money at the worst possible time.

00:09:08.640 | Let's say you have 100 grand saved up

00:09:10.720 | for 20% down payment for a $500,000 house, right?

00:09:13.320 | I'm just using round numbers here.

00:09:15.360 | If you're down 10% in a year, you now have $90,000.

00:09:18.120 | You're down $10,000, right?

00:09:19.600 | You're down 20%, you lost $20,000.

00:09:22.100 | Imagine having a house lined up

00:09:23.840 | and realizing you don't have enough money

00:09:25.160 | to come up with that down payment.

00:09:26.120 | So, sure, could this go the other way

00:09:27.760 | and stocks are up and you make an extra 5, 10, 15, $20,000

00:09:31.440 | if you're lucky, sure.

00:09:32.660 | But I think you have to weigh the regrets here.

00:09:34.460 | And you're right to worry about short-term market volatility

00:09:37.700 | but the reason itself doesn't matter.

00:09:39.180 | So my advice is however you wanna get out,

00:09:43.100 | you could do it slowly,

00:09:44.700 | but I think having that money in the stock market

00:09:47.140 | to begin with for a 12-month goal is pretty irresponsible.

00:09:51.620 | And I would get it out of the market if I could

00:09:53.420 | because I would rather know that money's there

00:09:55.500 | and available than take any risk with it.

00:09:59.300 | - Yeah, and like we've talked about ad nauseum,

00:10:01.600 | it feels like at this point,

00:10:02.440 | but you can actually get something on your cash.

00:10:04.600 | - Yes, that's the thing.

00:10:05.880 | People were complaining forever

00:10:07.120 | about not being able to earn anything in their cash.

00:10:09.160 | Now you actually can get something.

00:10:10.880 | - Yeah. - Right?

00:10:11.720 | So again, in my example,

00:10:12.560 | if you've got $100,000 and you're earning 5%,

00:10:15.200 | in a year, you could make an extra $5,000.

00:10:17.200 | I could cover your closing costs.

00:10:18.760 | - Right. - Right, so it's, yeah.

00:10:19.680 | So it's not like a situation

00:10:21.440 | where you're being forced out on the risk curve anymore.

00:10:23.680 | - Yeah, and we'll just ignore the fact

00:10:25.120 | that houses will go up another 20% in the next year,

00:10:27.400 | you know. (laughs)

00:10:29.500 | - Someone looking, but yeah, you're right.

00:10:31.060 | It's never been easier in the past probably 20 years

00:10:34.020 | to find somewhere to park that cash

00:10:36.180 | that is not the stock market.

00:10:37.340 | And the stock market is,

00:10:38.180 | you don't wanna be at the whims of the stock market

00:10:39.580 | of a flash crash or, you know, in early 2020,

00:10:42.380 | the stock market lost 33% in a month, basically.

00:10:45.660 | I mean, I'm not predicting that's gonna happen,

00:10:47.740 | but that's the kind of thing with the stock market

00:10:49.020 | that's always there just in case.

00:10:50.460 | So I would just avoid the stock market

00:10:52.780 | for short-term goals like this.

00:10:53.700 | - I never saw last year coming, you know.

00:10:56.800 | - Exactly. - Happened overnight.

00:10:58.740 | - Who knows?

00:10:59.580 | All right, next question.

00:11:00.820 | - Hey, this next one's a fun one from Justin.

00:11:03.860 | My wife is a middle school math teacher

00:11:05.460 | and I've been roped into teaching her students

00:11:07.340 | a personal finance one-on-one class

00:11:09.220 | during their last week of school.

00:11:10.700 | That can be brutal, last week of school.

00:11:13.040 | No one's paying attention.

00:11:14.500 | But I have a finance degree and consider myself

00:11:17.340 | to have sound personal finance practices,

00:11:19.660 | but teaching the basics to a group of sixth graders

00:11:21.860 | has me a little unsure of where to start.

00:11:23.940 | What are the best personal finance concepts to teach kids?

00:11:26.620 | Some things I have in my agenda,

00:11:28.160 | the power of compound interest,

00:11:29.480 | the power of diversification,

00:11:31.080 | and the importance of savings rate.

00:11:33.020 | But I'd love to hear how you would approach

00:11:35.320 | crafting a 60-minute lesson plan.

00:11:37.400 | - All right, Justin, I hate to sound harsh here,

00:11:39.520 | throw your entire lesson plan out the window right now.

00:11:41.900 | Sixth graders do not care about diversification

00:11:44.440 | or compound interest or the importance of a savings rate.

00:11:47.280 | Maybe when they're in high school or college, maybe,

00:11:50.360 | but at that age, they are not going to care

00:11:52.560 | about this stuff.

00:11:54.120 | I mean-- - Pokemon?

00:11:56.040 | Do sixth graders still care about Pokemon?

00:11:57.640 | - Well, I think a lot of this stuff doesn't matter

00:11:59.020 | until people actually experience it themselves.

00:12:00.880 | That's why even teaching personal finance in high school

00:12:03.760 | probably is just over people's heads in most cases.

00:12:06.560 | But I do think you could get them interested

00:12:08.720 | in business and money in certain ways.

00:12:10.480 | Like, talk to them about some of their favorite companies

00:12:12.200 | and how much money they make and how they make their money.

00:12:14.120 | Disney, Roblox, Hasbro, Mattel, Nike.

00:12:17.440 | My oldest daughter has gotten into Roblox lately,

00:12:20.120 | and I can see why that-- - I gotta be honest,

00:12:23.280 | I still don't even understand what Roblox is.

00:12:25.720 | I don't think I get it either.

00:12:26.560 | It's a game, but you have, it's kind of one of these,

00:12:28.720 | it's free to play, but then you have to buy stuff

00:12:31.000 | on the game, and I'm sure a lot of kids

00:12:33.280 | have their parents' credit card numbers

00:12:34.920 | and just buy stuff all the time

00:12:36.240 | and the parents don't even know it.

00:12:37.160 | - I love that business model.

00:12:38.800 | - So I think help these kids understand

00:12:42.060 | how companies make money and how they grow,

00:12:44.480 | and then maybe that'll help them understand

00:12:45.840 | why stock prices grow over time through earnings

00:12:48.000 | and these sorts of things and revenue

00:12:49.660 | and how a business works.

00:12:51.200 | Maybe that's more helpful.

00:12:52.040 | So one of my favorite examples of this for young people

00:12:54.440 | was Nike and the original Air Jordans,

00:12:56.440 | which I just watched air last weekend, which was fantastic.

00:13:00.160 | The first Air Jordan back in 1985, Duncan,

00:13:02.320 | what was the retail price?

00:13:03.760 | Not adjusted for inflation or anything.

00:13:05.160 | What do you think?

00:13:06.060 | - $80?

00:13:09.680 | - 65, close.

00:13:10.600 | So if you would have taken that 65,

00:13:13.240 | and Justin, I'm giving you this to use in your talk.

00:13:15.240 | You can take this word for word.

00:13:16.840 | What if you would have invested that $65

00:13:18.960 | instead of buying the shoes and wearing them out

00:13:21.520 | and throwing them away in a year,

00:13:22.800 | what if you would have instead invested in Nike shares?

00:13:25.480 | All right, John, throw the chart up here.

00:13:27.260 | That $65 grew into $61,000.

00:13:30.760 | It was over a hundred before,

00:13:31.740 | but Nike has fallen down a little bit.

00:13:33.240 | Obviously extreme example,

00:13:34.480 | but this just does a nice job of illustrating

00:13:36.040 | the difference between spending money and investing money.

00:13:38.740 | So I think the idea of compounding

00:13:40.720 | is an important concept to grasp.

00:13:42.720 | But again, I don't think these kids are gonna latch on

00:13:45.560 | to 10% growth in the stock market over 30 years.

00:13:49.200 | I don't think that's gonna help.

00:13:50.520 | So Duncan, have you heard the rice story before?

00:13:52.880 | Maybe this is a good way.

00:13:54.280 | So there's the old story about back in the medieval days,

00:13:57.760 | we're talking like when "Game of Thrones" happened,

00:13:59.640 | right, whenever that was.

00:14:00.920 | And there's a king who likes chessboards

00:14:02.880 | and a con artist is really good at making chessboards,

00:14:05.560 | right, and he goes to the king

00:14:07.200 | and he's selling him chessboards and he realized,

00:14:08.560 | oh, this king knows nothing about math.

00:14:11.040 | So he says, instead of giving me gold

00:14:13.560 | or fine clothes or whatever,

00:14:14.800 | how about you just give me enough rice

00:14:17.360 | where we start with one piece of rice

00:14:19.180 | on the first square of the chessboard

00:14:20.840 | and then we double it every time.

00:14:22.320 | So one, two, four, eight, 16, that sort of thing.

00:14:26.000 | And the king has all this rice.

00:14:28.400 | He says, that sounds great.

00:14:29.520 | So it doubles and it's pretty small.

00:14:32.400 | But then by the 20th square, I think or something,

00:14:34.160 | it's over a million grains of rice.

00:14:36.580 | By the 30th square, it's over 500 million.

00:14:38.640 | By the 40th, it's like a trillion grains of rice.

00:14:40.800 | How many other chessboards, 60 something?

00:14:43.280 | - I actually don't remember.

00:14:44.400 | And I should know that, I play chess.

00:14:46.840 | - And so then the con artist says,

00:14:49.280 | don't worry about the rice.

00:14:50.120 | You can just pay me in gold or land

00:14:51.140 | after he is up to trillions of grains of rice.

00:14:53.620 | - Sorry, Michael just walked in, so I'm a little distracted.

00:14:56.460 | - Okay, he's been known to do that.

00:14:58.220 | I don't know.

00:15:00.640 | So I'm saying use stories to talk about these concepts

00:15:03.540 | as opposed to giving people facts and figures and numbers

00:15:06.540 | and talking about the stock market.

00:15:07.780 | So I do like the idea of teaching young people

00:15:10.180 | the importance of money and personal finance, but...

00:15:13.980 | - Hey, Michael.

00:15:14.820 | He's got a lot of gear on there.

00:15:17.800 | But I mean, try to tell them stories

00:15:19.560 | that they're gonna remember,

00:15:20.400 | not just numbers and facts and figures,

00:15:22.320 | because most of them is gonna go in one ear and out the other

00:15:24.760 | and especially if it's towards the end of the year.

00:15:26.240 | So teach them some stories, maybe they'll remember

00:15:28.160 | and share with their parents.

00:15:30.160 | Most adults find this stuff boring too.

00:15:31.740 | I love finance and investing and all this stuff,

00:15:34.600 | but most people find it boring, even as adults.

00:15:37.440 | So kids are gonna find it even more.

00:15:38.400 | So I would figure out a way to talk about stories

00:15:41.500 | as opposed to numbers.

00:15:43.040 | - Right. - That's what I would...

00:15:44.740 | - When I was in sixth grade,

00:15:45.580 | I think you would have had to put it in skateboarding terms

00:15:48.100 | for me to have paid attention probably.

00:15:49.380 | - You were a skater?

00:15:50.220 | Did you have the hair over the face kind of deal too?

00:15:52.960 | - No, not really, no.

00:15:54.820 | - Okay.

00:15:55.660 | - I did have longer hair, but yeah, not like that.

00:15:58.300 | - All right, let's do another one.

00:15:59.620 | - All right, up next we have a question from Alex.

00:16:03.620 | I'm contributing to my 401k plan,

00:16:05.420 | 50% traditional before tax and 50% Roth after tax.

00:16:09.460 | I'm currently 31 years old

00:16:10.780 | and I like the idea of tax diversification now

00:16:13.120 | and in retirement.

00:16:14.840 | What happens once I reach retirement age

00:16:16.520 | from a tax standpoint?

00:16:17.840 | Where would I roll the balances to

00:16:19.320 | and how do distributions work?

00:16:21.560 | Do I have control over which bucket I pull from,

00:16:23.920 | Roth or traditional,

00:16:25.180 | or will there be forced pro rata taxation

00:16:28.160 | on all distributions?

00:16:30.080 | - Good financial planning question here.

00:16:32.360 | See, the thing is, I think a lot of people realize

00:16:33.960 | like making the contributions is a lot easier.

00:16:36.120 | Obviously saving some people is difficult,

00:16:37.480 | but making contributions is way easier

00:16:39.120 | than taking out withdrawals.

00:16:39.960 | And this is where financial planning comes in.

00:16:41.180 | So why don't we bring on a financial planner here,

00:16:44.620 | Alex Palumbo.

00:16:45.580 | - Hey, Alex.

00:16:47.740 | - Hi, Ben, hold in your enthusiasm introducing me.

00:16:50.340 | Seriously, it's okay.

00:16:51.340 | (laughs)

00:16:52.980 | - All right.

00:16:53.820 | - And I prefer if you refer to me

00:16:54.900 | as director of attire for today, if that's okay.

00:16:57.260 | - Come in, hi.

00:16:58.220 | - May I explain why?

00:16:59.180 | Is that okay?

00:17:00.020 | So, because Michael with the impromptu cameo

00:17:05.340 | recommended yesterday on your show,

00:17:06.900 | Animal Spirits #Plug, that it's now Hawaiian shirt season.

00:17:10.620 | You have to wear Hawaiian shirts now every day.

00:17:13.320 | So me, being an avid listener and follower,

00:17:16.060 | leave my apartment complex today in a Hawaiian shirt.

00:17:19.060 | It's 50 degrees, it's freezing out there.

00:17:20.900 | So what I do, I scramble.

00:17:22.860 | I throw on this fakakta raggedy polo,

00:17:27.060 | and I shouldn't have done that.

00:17:28.540 | So second plug, what I should do is pick up

00:17:31.220 | a lovely polo from Bird Dogs.

00:17:34.140 | They ship on June 15th highest quality polo shirt

00:17:37.980 | on the market. - You do look nice.

00:17:39.300 | - But mine was dirty, so I'm wearing this raggedy one.

00:17:41.060 | - Alex, you can be my salesman anytime.

00:17:42.940 | - So there you go.

00:17:43.780 | - This is why you're not the director of attire though,

00:17:44.820 | because you didn't check the weather

00:17:45.860 | before we left the house today.

00:17:47.100 | It's gotta be sunny if you're gonna wear a Hawaiian shirt.

00:17:49.380 | - All I listen to is Michael Batnick

00:17:50.860 | and whatever he says, I just do, blindly.

00:17:52.740 | - Maybe you're more of a director of retire.

00:17:55.500 | (laughs)

00:17:56.620 | - All right. - Nice.

00:17:57.740 | - So Alex is in his 30s, and he's already thinking ahead

00:18:00.980 | pretty far down the line.

00:18:02.100 | But this is obviously something older people

00:18:04.260 | that are in retirement have to think about more.

00:18:05.820 | So by the time he gets their taxes and RMDs and stuff,

00:18:08.060 | the rules are probably gonna be different.

00:18:09.140 | But how do you think about portfolio withdrawals

00:18:11.580 | when you have a client coming to you and saying,

00:18:13.140 | "Hey, I've got this money in a 401k and this in an IRA

00:18:15.340 | "and this in a taxable account."

00:18:16.940 | How do you think about it in terms of asset location

00:18:19.220 | and where they should be taking money from

00:18:20.500 | and planning out those withdrawal strategies?

00:18:22.260 | 'Cause again, that's way more difficult

00:18:23.820 | than it is to put money in.

00:18:24.740 | Putting money in is easy.

00:18:25.980 | Taking it out can be difficult

00:18:27.140 | because you have to think about all these moving pieces.

00:18:30.020 | - Yeah, it's a good point.

00:18:31.140 | It's a great question from Alex, excellent question.

00:18:34.380 | So I think it's actually a great idea to diversify

00:18:37.660 | the traditional and Roth contributions to your 401k.

00:18:41.780 | Now to establish the basics, when you establish pre-tax,

00:18:45.540 | you're not paying taxes on those contributions.

00:18:47.900 | You defer it until when you retire and you take distributions

00:18:52.540 | from the traditional 401k.

00:18:54.500 | It's taxed at ordinary income rates,

00:18:57.020 | the opposite with the Roth.

00:18:58.220 | You're paying ordinary income rates now,

00:19:00.700 | but then all of that growth is tax-deferred,

00:19:03.060 | not tax-deferred, it's tax-free,

00:19:04.700 | and then you never pay taxes upon the distributions.

00:19:07.740 | So that sort of answers this first part of this question,

00:19:09.780 | what happens when I retire?

00:19:11.900 | Sort of acts the exact opposite of how you contributed.

00:19:15.140 | And I do like the idea of overall 50/50 diversification

00:19:19.380 | for sure.

00:19:20.300 | There's obviously more nuances though.

00:19:21.620 | Like if you're in the highest income tax bracket right now,

00:19:24.340 | should you use a Roth?

00:19:25.700 | I know Bill Sweet would probably say yes,

00:19:27.220 | and I wouldn't disagree,

00:19:29.140 | versus if you're in the lowest income tax bracket right now,

00:19:32.300 | I would definitely not use a traditional

00:19:33.780 | 'cause you wanna take advantage

00:19:34.700 | of that very low income tax bracket.

00:19:36.260 | - I guess that's the point.

00:19:37.100 | He's not gonna be able to plan it out now,

00:19:38.380 | but when he gets there,

00:19:39.220 | having that diversification will help

00:19:40.380 | because you don't know what your spending's gonna be

00:19:42.140 | at that point.

00:19:43.020 | You don't know what the tax rates are gonna be.

00:19:44.300 | So maybe having that diversification can allow you

00:19:46.580 | to think through what the best bucket is to take from

00:19:50.620 | at the time instead of being pigeonholed

00:19:52.220 | into one bucket or the other.

00:19:54.100 | - It definitely adds a lot of flexibility.

00:19:55.940 | So now you'll have a Roth bucket, a traditional bucket,

00:19:58.780 | and then potentially like a non-qualified trust

00:20:01.180 | or brokerage bucket,

00:20:04.100 | and you can sort of play the flexibility tax game,

00:20:06.820 | which we do with our clients all the time,

00:20:08.340 | and it just saves our clients so much in taxes

00:20:10.940 | in terms of short-term distribution tax planning,

00:20:14.540 | and then long-term planning as well.

00:20:16.380 | To answer Alex's like very quick,

00:20:19.020 | more straightforward questions,

00:20:21.300 | you would roll the balances into an IRA from a 401k,

00:20:25.660 | unless from age 55 to 59 1/2,

00:20:30.500 | you can actually take distributions penalty-free

00:20:33.900 | from your 401k, and you cannot do that from your IRA.

00:20:37.420 | Duncan, did you know that?

00:20:38.740 | - Right, so if he retires early,

00:20:40.900 | he's got some avenues beyond the taxable account.

00:20:43.620 | - So I had a client retired at age 55.

00:20:46.060 | Instead of rolling over his entire 401k to an IRA,

00:20:49.260 | we kept a few years worth of basic living expenses

00:20:52.300 | in that 401k.

00:20:53.500 | So that's a pretty important four-year window

00:20:55.060 | 'cause that's a pretty common retirement age.

00:20:56.820 | And then the question,

00:20:57.660 | do I have control over which bucket I pull from?

00:21:00.100 | There's no such thing as pro-rata distributions.

00:21:02.340 | You can pull fully from the traditional or the Roth,

00:21:04.900 | a ton of flexibility,

00:21:05.740 | which is really one of the main benefits we discussed.

00:21:07.660 | - Yeah, so having some diversification here

00:21:09.620 | is probably not a bad decision.

00:21:11.860 | - For sure.

00:21:13.460 | - I like it.

00:21:14.300 | Okay, let's do another one.

00:21:16.060 | - Okay.

00:21:16.900 | So last but not least, we have a question from Robert.

00:21:21.020 | With the SBB collapse,

00:21:22.340 | a ton of employees lost money

00:21:23.480 | on employee stock option plans.

00:21:25.500 | How much of your net worth should be in your employer's stock?

00:21:28.580 | 5%, 10%, 20%?

00:21:31.500 | And this is one I'm sure a lot of people have after that,

00:21:34.980 | because a lot of these tech companies,

00:21:36.160 | that's how they compensated people, right?

00:21:37.500 | - The funny thing is, is that a few years ago,

00:21:39.360 | people were asking this question differently.

00:21:41.380 | Like, why shouldn't I go all in on my stock company?

00:21:43.740 | Now people are saying, maybe I should diversify.

00:21:46.820 | So Alex, you've had plenty of clients come to you

00:21:48.140 | over the years who made good money

00:21:49.220 | in concentrated portfolios.

00:21:50.900 | So let's talk about stock options

00:21:52.420 | and some of the thought process behind this here.

00:21:54.860 | - For sure, this is a super relevant topic.

00:21:57.420 | And I think for starters, we could do a primer

00:22:00.300 | on really the four most common types

00:22:02.860 | of employer and employee stock plans.

00:22:05.660 | Big John, give me the PowerPoint.

00:22:07.520 | - This is our first ever PowerPoint slides

00:22:11.060 | on Ask the Compound.

00:22:12.180 | So Alex, giving you a lot of leeway here.

00:22:14.380 | You did a rant on clothing

00:22:15.660 | and now you're doing a PowerPoint.

00:22:17.140 | - You're gonna absolutely love it.

00:22:19.420 | So there's really four different types.

00:22:21.700 | Restricted stock units, employee stock ownership plans,

00:22:26.060 | employee stock option plans,

00:22:28.380 | and then employee stock purchase plans.

00:22:30.300 | We're gonna go through each in like 15 to 30 seconds

00:22:32.580 | 'cause I think it's important to establish the difference.

00:22:35.620 | RSUs are the most common one that I see

00:22:38.700 | because they're the most simplistic.

00:22:40.540 | Very straightforward, when you're granted units,

00:22:43.300 | let's say 100 units of ABC stock,

00:22:46.340 | there's no tax nature at all.

00:22:48.200 | Then once they vest to you,

00:22:50.460 | that is taxed at ordinary income.

00:22:52.180 | So you get 100 shares at $100 a share,

00:22:55.540 | you have to pay $10,000 of ordinary income.

00:22:59.720 | Then when you sell it, you pay capital gains.

00:23:01.400 | Boom, easy to understand.

00:23:02.500 | Next.

00:23:03.340 | Employee stock ownership plans, Duncan, you still with me?

00:23:08.100 | - Yes.

00:23:08.940 | - The ownership plans is when the employer contributes.

00:23:13.700 | So your employer is just giving you money.

00:23:15.220 | It's great.

00:23:16.060 | It goes into a pre-tax account,

00:23:18.420 | and then when you wanna take distributions,

00:23:21.660 | it's taxed at ordinary income rates to you.

00:23:25.600 | If you wanna defer that, you can roll it into an IRA,

00:23:28.980 | but this is where NUA, net unrealized appreciation,

00:23:33.780 | comes into play.

00:23:35.020 | We're not gonna go into that,

00:23:35.900 | but that's a very important concept.

00:23:37.500 | Next big job.

00:23:38.340 | - You got three exclamation points there,

00:23:39.180 | so it has to be important.

00:23:40.180 | - NUA is absolutely huge.

00:23:41.980 | I think actually on my first appearance,

00:23:43.440 | we went over NUA a little bit.

00:23:45.740 | The third one is a little bit more complex.

00:23:48.740 | It's employee stock options.

00:23:50.620 | There's two types, NQSOs and ISOs.

00:23:53.220 | We're gonna only focus on NQSOs.

00:23:54.860 | They're a little bit more common.

00:23:56.340 | Not taxed when you're granted.

00:23:58.340 | They're not even taxed when they vest.

00:23:59.900 | Duncan, can you believe it?

00:24:01.700 | - Sounds too good to be true.

00:24:03.140 | - They're only, but there is a kicker,

00:24:05.500 | some caveats, and some risks.

00:24:07.080 | They're only taxed when you exercise them.

00:24:11.260 | So the difference between the strike price

00:24:14.700 | and the market value, that's taxed.

00:24:17.380 | And then subsequent sales are sort of taxed,

00:24:19.260 | like capital gains.

00:24:20.500 | And that bargain element is taxed at ordinary income.

00:24:22.960 | But these can be completely worthless.

00:24:26.100 | They can just expire worthless.

00:24:28.300 | We'll get into that later.

00:24:29.340 | Last one, big job.

00:24:30.980 | An employee stock purchase play.

00:24:33.660 | These shares, pretty much you have to buy these shares.

00:24:36.880 | So it's sort of where you're buying something

00:24:38.600 | and you're not just giving it.

00:24:39.820 | And you typically get a five to 15% discount

00:24:42.580 | on the market value.

00:24:44.140 | And you purchase it with post tax dollars.

00:24:45.980 | - And these are usually a publicly traded corporation,

00:24:48.900 | right, where you get a,

00:24:49.940 | it could be Walgreens or something like it, or Pepsi.

00:24:52.140 | You can buy it at a 10 or 15% discount

00:24:54.420 | and you can do it on a set basis, right?

00:24:56.380 | - When you do that, is there a lockup?

00:24:58.260 | Because otherwise, wouldn't people just arbitrage that

00:25:00.020 | and immediately sell it for a profit?

00:25:02.080 | - I have no idea what Duncan means.

00:25:05.380 | - If you're getting a discount when you buy the stock

00:25:07.420 | from your own company,

00:25:08.600 | if you're immediately getting a 15% discount,

00:25:10.980 | could you not just sell it on the open market?

00:25:12.700 | - Absolutely amazing question.

00:25:14.000 | It's almost like this next slide completely answers that.

00:25:17.020 | - Okay, let's see it.

00:25:18.180 | - So a little bit intricate here, but stay with me.

00:25:20.820 | I think I'll be able to explain it.

00:25:22.060 | So this is how it typically goes.

00:25:23.740 | First, Duncan, you're offered the stock

00:25:27.060 | at let's say $10 a share,

00:25:28.940 | but you cannot purchase it until a year later.

00:25:32.900 | And let's say the purchase price is $20.

00:25:35.780 | Then in order to have a qualifying disposition,

00:25:40.040 | you have to sell it two years after it was offered, right?

00:25:42.780 | So that's how it sort of answers your question, Duncan.

00:25:44.520 | And let's say the stock at that point is $30.

00:25:46.800 | Now to be a qualifying disposition,

00:25:50.880 | that discount that you paid, right Duncan,

00:25:52.680 | because it was worth $10, but you only paid 8.50 for it,

00:25:56.240 | that discount is taxed at ordinary income.

00:25:58.360 | There's no free lunch here.

00:25:59.560 | Of course you're gonna get taxed at ordinary income.

00:26:01.520 | But the rest of that game,

00:26:02.680 | and I thought that this is like, this is a pretty big deal.

00:26:05.300 | That entire amount from 10 to 30

00:26:08.500 | is taxed at long-term capital gains.

00:26:10.480 | So even though you purchased it at 20,

00:26:12.980 | you pay long-term capital gains from 10 to 30.

00:26:15.340 | That's huge.

00:26:16.180 | A disqualifying disposition is

00:26:17.620 | if you don't follow those rules,

00:26:19.040 | you pay ordinary income tax on pretty much everything,

00:26:21.740 | except for the discount.

00:26:22.700 | - Get these numbers out of here.

00:26:23.540 | - Yeah, get these numbers out of here.

00:26:24.440 | - All right, but so that makes sense.

00:26:26.300 | So Duncan's question was, there is no free lunch here.

00:26:29.780 | - Right, and so you go from paying $22

00:26:33.620 | of ordinary income tax

00:26:36.060 | to only $1 of ordinary income tax.

00:26:38.660 | That's a big difference.

00:26:39.500 | - This is why financial planners exist,

00:26:40.460 | because this stuff is complicated.

00:26:41.920 | - Right.

00:26:42.760 | - All right, back to the original question.

00:26:44.520 | How much should you have?

00:26:45.360 | You've had people come to you

00:26:46.360 | with concentrated positions in the past,

00:26:47.920 | probably anywhere from 5% to,

00:26:50.080 | what's as high as you've seen?

00:26:51.720 | 80% maybe?

00:26:52.560 | - 5% to 100%, it's a huge range.

00:26:54.840 | - I know we've had people with 90% of the net worth

00:26:58.000 | in their company's stock.

00:26:59.320 | And they know in their heart of hearts,

00:27:01.680 | they need to diversify.

00:27:03.080 | Some people are worried,

00:27:03.920 | well, I could be leaving money on the table.

00:27:05.640 | But how do you think about this idea

00:27:07.080 | of still making money in the stock

00:27:09.080 | versus reducing your risk and spreading your bets?

00:27:12.480 | - Yeah, first thing I say is,

00:27:13.680 | typically, your entire career is tied

00:27:17.300 | from an income perspective to the company, right?

00:27:20.540 | They're the ones paying your salary.

00:27:22.100 | So if you own 100% of your portfolio,

00:27:23.760 | or really any of it, of your investable assets,

00:27:26.540 | you're doubling down.

00:27:27.680 | That's the first thing I'd like to mention.

00:27:30.280 | The employee client typically knows more

00:27:32.080 | about the company than I do,

00:27:33.580 | but they're inherently a little bit more biased.

00:27:37.220 | I've seen clients with an employee stock ownership plan

00:27:40.580 | in oil and gas companies, multiple clients that I have,

00:27:43.980 | they pretty much have their entire net worth

00:27:45.300 | in this company, and now they have millions of dollars.

00:27:47.860 | I've had clients who had RSUs in the regional banks

00:27:51.540 | that you mentioned, and they had 200K drop to zero now.

00:27:55.140 | And that's a disaster.

00:27:56.540 | I had a client who had options

00:27:58.980 | that were worth about $5 million.

00:28:01.220 | Now they're worthless,

00:28:03.020 | 'cause you can't even exercise the options.

00:28:04.940 | So I've seen the whole gamut of clients who work at Google,

00:28:07.660 | and their RSUs are just steadily vesting,

00:28:10.220 | and they're performing better than a lot of the market.

00:28:12.500 | So I've seen the whole gamut.

00:28:14.000 | There are certain strategies you can implement, though.

00:28:16.380 | Like, for example, it's all about the person.

00:28:18.740 | If you wanna take more risk, how about this, Duncan?

00:28:21.360 | When the stock goes down a lot,

00:28:23.920 | sometimes people have the options

00:28:25.280 | to choose between stock options and RSUs.

00:28:28.320 | You can maybe switch a little bit more to options

00:28:31.380 | when the stock goes down a lot.

00:28:33.500 | That's obviously a risky proposition,

00:28:34.920 | 'cause options can be worthless.

00:28:36.560 | But when it goes up, you have that leverage component,

00:28:39.340 | which is why Duncan, of course, loves that option.

00:28:42.020 | And there's everywhere in between.

00:28:42.860 | - Duncan's middle name is Risk.

00:28:43.680 | He would like this one.

00:28:44.520 | - So RSUs are always gonna be worth something, typically,

00:28:48.160 | and options can easily be worthless.

00:28:50.340 | - I do think, obviously, the level is a comfort thing,

00:28:55.860 | but I don't know.

00:28:57.140 | I think anything more than 10 to 20%

00:28:59.820 | is probably a little irresponsible.

00:29:01.860 | I would say that that's a pretty good line in the sand.

00:29:03.940 | - 20% seems high.

00:29:05.620 | - Yes, right.

00:29:06.460 | - But tell that to someone who's been working at Google

00:29:08.600 | for the past 10 years.

00:29:09.440 | - I do agree with you that you work for the company,

00:29:11.780 | you probably become a little overconfident,

00:29:13.180 | and it's gonna be harder for you

00:29:14.020 | to see the potential downside.

00:29:16.100 | But if you were someone who worked at General Electric

00:29:17.580 | and you were the biggest company in the S&P 500 in 2000,

00:29:20.300 | you wouldn't expect your stock to fall 75%

00:29:22.760 | over the next 20 years or whatever it is,

00:29:24.740 | and just be decimated.

00:29:26.340 | So that's what you're trying to protect against.

00:29:28.460 | - It's just like what you said earlier.

00:29:29.280 | - And back to Justin for question three,

00:29:31.520 | for teaching the kids.

00:29:33.100 | - Don't keep all your eggs in one basket.

00:29:34.660 | Right, that's it, easy.

00:29:35.660 | Easy story.

00:29:36.500 | - And what you said earlier,

00:29:37.340 | it's like people don't understand risk

00:29:39.460 | until they live through it.

00:29:40.820 | - Yes.

00:29:41.640 | - It's unfortunate.

00:29:42.480 | - It's regret minimization.

00:29:43.660 | Okay, all right.

00:29:45.140 | Alex, you're fired as director of retire for,

00:29:48.300 | sorry, for not wearing the right shirt today.

00:29:50.860 | - Oh my God.

00:29:51.700 | - Next time director of retire.

00:29:53.460 | Thank you for having me.

00:29:54.740 | - Yeah. - Thanks, Alex.

00:29:55.580 | - As always, yep.

00:29:56.400 | Remember, you can email us,

00:29:57.240 | askthecompoundshow@gmail.com.

00:29:59.820 | If you wanna get that bird dog free Tumblr,

00:30:01.260 | ATC is the code.

00:30:03.980 | Remember, also free to send us a voice memo or a video.

00:30:06.540 | We're gonna play these one of these times.

00:30:08.220 | Happy to personalize this.

00:30:10.240 | Hit that like button,

00:30:11.080 | subscribe, all those good things,

00:30:12.920 | and we will see you next time.

00:30:14.260 | - Thanks everyone.

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What if the U.S. Government Defaults?

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