Solo 401(k) accounts from Vanguard, with beneficial illustrations and calculations

One of the great advantages of being self-employed is the ability to open and manage your own small business retirement account. Employed people have to either take or leave their employer's 401(k) or 403(b) plan offerings, regardless of the quality or cost of the funds it offers, while the self-employed get to choose their own plan provider and pick exactly the assets they want to invest in. Naturally, many choose Vanguard, and since I recently opened a solo 401(k) with them, I thought it would be useful to share my experience.

Opening an account (1): selecting funds

To open a solo 401(k) with Vanguard you have to download and print the "Individual 401(k) kit for employers" from their small business website. The kit is pretty straightforward, although there are a few sections I want to highlight.In section 3 of the New Account Form you have the option of opening either a traditional, pre-tax account, a Roth, post-tax account, or both.If you open a pre-tax account, you have to select at least one fund to receive your contributions:Likewise if you open a Roth account, you have to select at least one fund:There's a $20 annual fee charged per fund held in each account, so if you open both accounts you'll have to pay $20 per fund each year, even if you hold the same fund in both accounts. The $20 fee is waived if you have $50,000 in assets across all your Vanguard accounts (so-called "Voyager services").Note that Solo 401(k)'s do not have access to Vanguard's lower-cost Admiral shares. That matters for two reasons: first, you'll pay slightly more for funds that you currently own as Admiral shares. That's bad. But it also matters because when people compare the fees on Vanguard's all-in-one funds to a "do it yourself" portfolio of Vanguard funds, they are usually comparing the all-in-one fund costs to the cost of Admiral shares. But if you don't have access to Admiral shares, that's not the right comparison.For example, Vanguard 500 Admiral shares have a hyper-low expense ratio of 0.05% — a third the cost of a Target Retirement or LifeStrategy fund. But Vanguard 500 Investor shares, the ones you have access to in a Solo 401(k), have an expense ratio of 0.16%! Suddenly the comparison doesn't seem so compelling, particularly if it comes with the added $20 per-fund fee and the additional hassle of periodic rebalancing. That's one reason I chose the LifeStrategy Growth fund for my 401(k), as you'll see below.

Opening an account (2): designating beneficiaries

Vanguard has what appears to be an extremely straightforward system for designating beneficiaries. First, you select your primary beneficiary:Then, you select your secondary beneficiary:This is not, in fact, an extremely straightforward system. As my primary beneficiary, I selected "To the person I'm married to at the time of my death," and as my secondary beneficiary I selected my partner. About a week later I got a call from Vanguard to clear up their confusion. It turns out that in spite of all logic and reason, you're only supposed to select "To the person I'm married to at the time of my death" if you're already married, which seems to me to defeat the purpose of such a checkbox, but what do I know?

Making contributions

Once Vanguard has accepted your plan documents, you'll receive a barrage of mail from them, including information on configuring your online account administrator access. Unlike the fairly powerful personal investor interface, the small business interface is extremely primitive:When you select "Make a contribution online" you're first asked which tax year the contribution is for, and then taken to this screen:The "Individual 401(k)" contribution fields are for pre-tax contributions, which can be made as employer or employee contributions (more on that in a moment). The "Individual Roth 401(k)" contribution fields are for post-tax contributions, which can only be made as employee, not employer, contributions.

Contribution limits

Solo 401(k) contributions limits aren't hard, they're just complicated. I think the best way to think about them is in three parts:

• 100% of net self-employment income, minus half the self-employment tax, up to $18,000. If your net self-employment income from Schedule C is less than $19,491, then you can contribute 92.35% of your net self-employment income in the left-hand "employee" contribution columns. You can split that amount between the pre-tax Individual and after-tax Roth fields however your own tax needs dictate.
• 25% of your remaining net self-employment income, minus half the self-employment tax. If your net self-employment income is $30,000, then after deducting half the self-employment tax ($2,295), you're left with $27,705. You can contribute 100% of the first $18,000 in the left-hand "employee" column and 25% of the remaining $9,705 ($2,426) in the pre-tax right-hand "employer" column.
• $54,000. The most you can contribute in total to a solo 401(k) plan per calendar year is $54,000 in 2017. To make $54,000 in solo 401(k) contributions you'd need to make $175,419 in net self-employment income. Deducting half the self-employment tax would leave you with $162,000, and after contributing the maximum $18,000 in employee contributions you'd be left with $144,000, 25% of which is the $36,000 in employer contributions you need to reach the maximum.

Note that you do not need to actually make contributions in this order!This is simply the order that will maximize your contributions for a given level of self-employment income. You can reach the $54,000 contribution cap exclusively from employer contributions. However, the required net self-employment income is much higher: $54,000 is 25% of $216,000, which is almost $234,000 in net self-employment income after the self-employment tax is added back in.And of course if you want to take advantage of Individual Roth 401(k) contributions those can only be made as employee, not employer contributions.

Adding and exchanging funds

An important benefit of Vanguard retirement accounts is that it's possible to contribute to funds without meeting the minimum initial investment requirement. In other words, you don't need to contribute $3,000 in order to purchase shares of a fund that otherwise has a $3,000 minimum investment.However, this benefit is only extended to contributions processed through the small business investing portal. When you log into your personal investor account, you'll see your 401(k) account(s) there but won't be able to transact the funds in those accounts until you meet the minimum investment requirements.If you want to add a new fund to your 401(k) but don't want to exchange shares in an existing fund, Vanguard can do this over the phone if you call 1-800-205-6189. The reasons for doing so might be to trigger the minimum investment waiver for future contributions to the account, or simply to diversify your existing funds.

Conclusion

Solo 401(k) plans are a way to defer taxes on a substantial amount of self-employment income and, in Roth accounts, potentially avoid taxes entirely by making Roth contributions in years when you are able to pay little or no federal income tax.Vanguard's Solo 401(k) kit makes it just about as easy as possible to get started, given the legal requirements involved. And even if you make a mistake when designating your beneficiaries or selecting funds, their phone personnel have been extremely capable every time I've had to speak with them (including researching this post).And of course, best of all a Vanguard Solo 401(k) gives you access to Vanguard's suite of low-cost mutual funds!

What do you think you are doing when you diversify investments?

Over the last year or so, I've read 20-30 books on investing, including short handbooks like The Index Card and somewhat more technical volumes like Jack Bogle's Common Sense on Mutual Funds.The thing virtually every book I've read on investing has in common is a recommendation that part of a portfolio be invested in bonds, and it took me a long time to understand why.I finally did come to a few conclusions on this score, which I shared in this modestly interesting thread on the Saverocity Forum.I'd like to take a slightly different approach to the same question, through the prism of some financial independence bloggers who are kind enough to share their actual investment portfolios online (or at least what they claim to be their actual investment portfolios). These aren't bloggers I necessarily follow myself, but are rather bloggers who seem to have a general attitude towards investing that reflects mine: invest as much as possible in funds that cost as little as possible.

The White Coat Investor

Here's the latest investment portfolio shared by the White Coat Investor blog:

• 75% Stock
•    50% US Stock
•       Total US Stock Market 17.5%
•       Extended Market 10%
•       Microcaps 5%
•       Large Value 5%
•       Small Value 5%
•       REITs 7.5%
•    25% International Stock
•       Developed Markets 15%
•       Small International 5%
•       Emerging Markets 5%
• 25% Bonds
•    Nominal Bonds (G Fund) 12.5%
•    TIPS 12.5%

Physician on FIRE

Here's the latest investment portfolio shared by Physician on FIRE:

JL Collins

I'm a bit confused by how JL Collins describes his holdings, but I think he claims to be currently holding:

• 75%-80% VTSAX (Total US Stock Market)
• 25% VBTLX (Total US Bond Market)
• 5% "cash"

What benefits might diversifying investments conceivably provide?

If you happen to be a fan of these bloggers, trust me when I say I'm not trying to "criticize" these investment decisions. In an era of comprehensive historical market data and cheap or free backtesting data, I'm sure these portfolios have a higher (lower?) Sharpe ratio (or whatever) than my portfolio, and if that's what you want then you can build such a portfolio yourself, or copy one of theirs.But unless you know why you're constructing your portfolio in the way you are, it seems to me vanishingly unlikely such a portfolio is the straightest path towards achieving your investment goals.Of course, there's no sense in talking about "diversifying" a portfolio unless you have a portfolio in the first place, so I'll use as a "baseline" portfolio the Vanguard Total Stock Market Index Fund, VTSAX, a fund that all three of the bloggers above use as their largest single holding. Why might a well-informed investor/blogger deviate from that portfolio?

• The belief that another asset class will provide a higher return on investment. This appears to be the logic behind the White Coat Investor and Physician on FIRE portfolios, with their addition of small-cap, mid-cap, and value funds to the core VTSAX holding. The investors appears to believe that such funds will generate higher returns than the market-cap-weighted total stock market index.
• The belief that an additional asset class will provide a more stable account balance. I don't know why an investor would be interested, in general, in the stability of their account balance, but it is a fixture of financial writing that this is something people are, in fact, deeply interested in. This is how JL Collins explains his bond holdings: "Bonds provide income, tend to smooth out the rough ride of stocks and are a deflation hedge. Deflation is what the Fed is currently fighting so hard and it is what pulled the US into the Great Depression. Very scary" (emphasis his).
• Tax-loss harvesting. As Physician on FIRE explains, "Some of the complexity comes from tax loss harvesting, which results in me holding four funds in the taxable account, rather than two." In other words, he does not believe that his added diversification will improve returns and he doesn't believe it will lead to a more stable account balance, he diversifies solely for the purposes of not having substantially similar funds in his taxable account so he can trade them against one another for tax reasons.

If you want to diversify, first figure out why

After all the research I've done into investing, I was personally shocked to learn this, so don't be surprised if it's a shock to you as well: diversification doesn't increase long-term returns. Diversification only increases long-term risk-adjusted returns, which is to say, returns adjusted for volatility in your nominal account balances. If you don't care about your nominal account balances, diversification away from equities is a pure drag on your investment performance.You may, in fact, be the kind of investor that cares deeply about your account balances, in which case, frankly, I don't have any recommendation besides a heavy allocation to cash (here's a great resource for high-interest checking accounts you might consider).But if you're a long-term investor who doesn't care about your nominal account balances, you should diversify away from broad market indices only with caution and only when you have good reasons for doing so.

The many flavors of investing activity

I've heard a lot of talk lately about the issue of investors and investment advisors who claim to be investing "passively" but are really just actively managing low-cost index funds. One reason this issue is interesting is that most research into the superiority of index investing seems to ignore it completely.For example, when Jack Bogle says the passively-managed Vanguard 500 index fund has to outperform all actively managed large cap funds after taxes and fees, he's making a very specific (very true) claim: that a dollar invested at the start of a period in the Vanguard 500 will outperform (after taxes and fees) the average performance of a dollar invested in every actively managed fund. If all passive investors together earn the performance of the market minus fees, then all active investors together must also earn the performance of the market, minus taxes, fees, and trading costs. This is mechanically true, not an ideological argument of any kind.On the other hand, the relative performance of the same dollar is completely unknown if you're buying into the fund every time it goes up and selling every time it goes down, or vice versa. Even though you're investing in a passively-managed index fund, if you're actively trading it's impossible to predict your relative performance compared to "passively" buying and holding an actively managed fund!With that in mind, here are 3 kinds of activity that are guaranteed to change your performance relative to the market, one way or another.

Active fund selection

Say that you are committed to investing exactly $1,000 each month in a low-cost, passively-managed index fund. However, each month you decide from scratch which fund to invest in. Some months you think the domestic stock market's overvalued and you invest in a total international stock fund instead. Other months you think the domestic stock market's got a lot of upside potential so you buy in there instead. Other months you see that below-investment-grade bond yields have ticked up and buy $1,000 of that fund instead.I suspect if you really feel compelled to introduce some kind of activity into your investment decisions, this is the most defensible: you're consistently adding the same dollar amount to your investments each month, you're investing in low-cost, passively-managed index funds, and you'll end up either modestly underperforming or modestly overperforming a truly passive approach.You still shouldn't do this, but I find the impulse completely understandable.

Active timing of buying decisions

An approach that is much more likely to see you underperform over time is timing your buying decisions. There are a number of ways you might execute such a "strategy." In a single-fund portfolio, you might wait until the price/earnings ratio drops below some fixed number before buying, or you might wait until some arbitrary drawdown from the fund's high point before adding additional funds.The two biggest problems with this approach are the certainty of missing out on dividend yield and the likelihood of jamming yourself due to tax considerations.For the first point, consider that the Vanguard 500 at its current price yielded 1.89% in dividends over the last 4 quarters. I am absolutely positive that the Vanguard 500 will experience at least one 10%, 20%, and 50% correction in the next decade, but I am completely agnostic as to whether they will occur tomorrow or 10 years from today, which means I'm completely agnostic about the level from which the drawdown will occur, which could easily be 11%, 25%, or 100% higher than today.The second point is even more devastating if you're making contributions to a tax-advantaged account with annual funding limitations. Say you can make 2017 contributions to your IRA on any date between January 1, 2017, and April 16, 2018. You would obviously like to make your purchase on the date within that period when your contribution will purchase the most shares possible. The problem is that each day that elapses is a day when you're unable to make your purchase, even if it turns out to have been the cheapest entry point. When April 16 comes around, you're forced to make your contribution, even if it's the absolute most expensive point during the year, and you'll meanwhile have missed out on 5 quarterly dividend distributions.

Active selling decisions

The absolute worst kind of activity you can introduce into your account is selling activity. I do not consider this to be because of tax consequences, because I think tax consequences are utterly irrelevant for most investors and wildly overblown even for the small group of investors they do affect.The problem with selling activity is that it requires you to be right twice: you have to correctly guess when the price of a fund will drop, and exit before it does so, and then you have to correctly guess when it is at or near its bottom in order to reenter before it rises again (or guess when some other fund will start to rise).The one kind of selling that makes any sense is rebalancing from appreciated assets to less-appreciated assets within a tax-advantaged account. For example, a 50/50 domestic/international portfolio may naturally change its weight to 60/40 if domestic stocks drastically outperform international stocks. I don't think you should do that, but I understand the logic behind it if you have some reason to be invested in a 50/50 portfolio to begin with.

What is a passive investment portfolio?

There are two ways to construct a truly passive investment portfolio:

• Make regular, identical purchases of a fixed asset allocation, and never change it.
• Make a single purchase of a fixed asset allocation, and never change it.

As an example of the first, you might contribute a fixed dollar amount to a single domestic index fund every week or month. As an example of the second, you might make a single purchase of a fund or set of funds and never buy or sell them again.Both choices have their advantages and disadvantages: the first will give you access to the range of asset prices across several business cycles, allowing you to buy in at the average value of each asset class. The second gives you access to more dividend distributions by making your contributions up front, but locks in your cost basis at the moment you make your single initial investment decision.While both are fine, I believe only a tiny minority of investors are capable of pursuing either option. If, like most investors, you aren't able to behave completely passively, you need to decide what kind of activity to introduce into your portfolio.

• Actively selecting passively-managed low-cost funds that you'll hold forever is unlikely to present much of a drag on your portfolio, since you'll be fully invested at all times in whichever funds you ultimately pick.
• Actively timing buying decisions isn't a great idea, since you'll find yourself with investable cash on the sidelines while you could have been accumulating shares that provide a stream of future income.
• But actively selling shares is virtually guaranteed to make you underperform basic market indices all year, every year.

A final option is to "top up" underperforming investments with each new additional investment, so rather than selling off overperforming funds in order to buy underperforming funds you might make larger contributions to the underperforming funds until they return to their "ideal" allocation. This is still market timing, but perhaps the most harmless of all forms of market timing if you insist on introducing activity into your portfolio — which, to be perfectly honest, you probably will.

You can pay someone to harvest capital losses for you, but why would you?

A current fad in the world of personal finance and investing is so-called "tax-loss harvesting." If you're not familiar with the concept, tax-loss harvesting refers to the perfectly true observation that up to $3,000 in capital losses can be deducted from ordinary income each year, and it's one of the biggest selling points of "robo advisors," the automated investing services that manage accounts on your behalf.Due to my unfortunate literal tendency, I had the apparently unprecedented idea of checking whether this is actually worthwhile. This isn't rocket science: we need only compare the value of a $3,000 reduction in ordinary income to the cost of maintaining an account with one of these services.There are a number of automated advisory services, so for simplicity's sake let's take a look at the big three: Wealthfront, Betterment, and FutureAdvisor. Purely from the generosity of my spirit I'm going to give each service the benefit of the doubt and assume that they really will achieve $3,000 in capital losses each and every calendar year.

What are $3,000 in capital losses worth?

In the United States we have 7 marginal income tax rates, and since the $3,000 in capital losses will be deducted from your income at the margin, the value of the loss depends on your marginal income tax rate:

• 10%: $300
• 15%: $450
• 25%: $750
• 28%: $840
• 33%: $990
• 35%: $1,050
• 39.6%: $1,188

For an automated advisory service to be worth paying for, the amount paid to the service must be lower than the value of the tax-loss harvesting the service provides. Since automated advisory services charge based on the amount of money they manage, this creates the curious situation where the value of the service goes up the higher your marginal tax rate and goes down the more money you hold with them.What we can easily identify is your breakeven point, where you begin to pay more in advisory fees than you receive in reduced income tax liability.

Wealthfront

Wealthfront has a 0.25% annual advisory fee and claims to provide tax-loss harvesting services to every client, regardless of account balance, and manages your first $10,000 invested for free. Assuming they're able to realize $3,000 in capital losses on accounts of any size, the breakeven points for someone in each marginal income tax bracket are:

• 10%: $130,000
• 15%: $190,000
• 25%: $310,000
• 28%: $346,000
• 33%: $406,000
• 35%: $430,000
• 39.6%: $485,200

Betterment

Betterment charges the same 0.25% annual advisory fee as Wealthfront, but doesn't exempt the first $10,000 from fees so the breakeven points are identical to those above, less that $10,000 amount.

FutureAdvisor

FutureAdvisor charges 0.5% of assets under management each year, which means you'll pay more in advisory fees than you earned in reduced income tax liability at the following account values:

• 10%: $60,000
• 15%: $90,000
• 25%: $150,000
• 28%: $168,000
• 33%: $198,000
• 35%: $210,000
• 39.6%: $237,600

What about offsetting capital gains?

It's also true that capital losses can be used to offset capital gains. While only $3,000 of capital losses can be used to offset ordinary income, an unlimited amount of capital losses can be used to offset realized capital gains.This leads me to the rather embarrassing question I'm forced to ask: why do you have capital gains?Last year the Vanguard 500 (VFIAX) distributed $0 in capital gains.Last year the Vanguard Total International Stock Index (VTIAX) distributed $0 in capital gains.Same with Emerging Markets, Europe, and the Pacific.If you're recording large capital gains each tax year you definitely have a problem, but that problem isn't going to be solved by automated tax loss harvesting, that problem is going to be solved by getting — and staying — in some low-cost Vanguard index funds. That's true whether you have invested $100,000 or $1,000,000. Constructing a portfolio that spins off capital gains each year and then paying somebody to offset them with capital losses isn't a second-best, third-best, or fourth-best option.It's literally the worst option.

Go ahead and roboinvest if you think they know something you don't

I do not have any reason to believe that backtesting is an interesting or useful way to build a portfolio. But I do believe backtesting is an extremely popular way to build a portfolio, and I'm sure these and the many other automated investing firms are great at it. So if you, like many investors, believe that backtesting is an interesting and useful, and hopefully profitable, way to build a portfolio, I don't see any reason not to invest with one of these automated investing services.If you're right, and these model portfolios outperform buying and holding some low-cost Vanguard funds, then you win twice: you outperform us lazy, skeptical investors and you make a little money each year harvesting capital losses.If you're wrong, then the good news is that you're not alone, but the bad news is you're paying out of pocket each year for the privilege of underperforming.