The financial services industry pours millions of dollars into advertising in an attempt to convince you that you need their help to find a solution. Luckily, most of us are making the same mistakes over and over again (myself included), so you can learn from us. Here’s the most common mistakes that I see.
LET’S BE HONEST. Law school didn’t teach us a lot about personal finance. We barely covered the law and many corporate lawyers would probably say the skills we learned related mostly to litigation. But then you’re thrust into a career, with a ton of student loan debt, and you realize you have a second job (whether you want to or not) managing your money. Let’s make sure we’re doing it right. Here are some of the top financial mistakes lawyers make:
1. Inadequate Savings Rate
Lawyers need to have a higher savings rate than the general population. You must save more than 5-10% to be successful.
Why? Because lawyers get a late start in the workplace. A typical college-grad expects to spend 43 years in the workforce. A typical lawyer might spend 35 years working.
Not only do lawyers start saving later in life, but before they can begin saving for retirement they must contend with significant student loan debt.
In other words, if you have student loan debt it will take some time before you reach net worth zero, which puts you even further behind. To catch up, you should be both reducing debt and saving for retirement.
For these reasons, lawyers need to be saving significantly more than 5-10% of their income. How much should be saving? The math is surprisingly simple. You need to save 25 times your desired annual income in retirement. Think you would be fine living off $100,000 a year? You need $2,500,000.
Keep in mind that your spending in retirement will almost certainly be substantially less than your current spending. You won’t be saving for retirement, nor will you be paying for most insurance products (e.g. life, disability, etc).
Also, your taxes are likely to be lower, particularly if you’re working in an expensive city like NYC or San Francisco. Retired people also have a lot of free time, so you won’t be spending money for prepared meals, cleaning services or someone to fold your laundry.
Lawyers work long and often unpredictable hours and unwind late in the evenings with colleagues and friends. Hight stress jobs have a mentality of “work hard, play hard”. The result is that it’s easy to over-consume entertainment, alcohol and food.
The financial and physical cost of such over-consumption cost be high, but more importantly to you, it’s unnecessary. Unless you’re keeping track, most people will only have a fuzzy idea of the total amount they’re spending on entertainment each month.
If you’re trying to cut back, ask yourself how many times you need to go out each week? Do I need top-shelf alcohol for every drink? Do I need to be spending $80 at a restaurant 2 times a week plus have brunch with friends? What about movies/shows/sporting events? Do I need more entertainment or do I need more sleep? What about my cable bill? If you take some time to audit your entertainment expenses, it’s easy and painless to cut unnecessary expenses from your life.
I’m willing to bet you’re paying for things right now that you don’t use or enjoy.
3. Being Unaware of Firm Benefits
I’m always surprised when I discover a lawyer that isn’t aware of the firm’s entire benefits package. From large firms to small firs, nearly Every employer provides a bonanza of benefits for the taking.
If you’re in Biglaw, the firm will probably pay for meals after a certain hour or taking a car home .
If you’re at a small firm, you may have a high-deductible healthcare plan, which gives you access to the Health Savings Account. You might also be able to participate in taking transit deduction. All you need to do is take some time to understand you firm’s benefits.
Firms often also pay for things like bar membership, attorney registration fees and sometimes travel for conferences. They pay for professional development and continuing legal education. Firms subsidize your mobile phone bill. They even provide you with corporate discounts on your mobile plan (just enter your email and save 15%). Dust off the new hire packet and see what you’re missing.
4. Poor Tax Management
Financially successful lawyers manage their taxes and use tax-advantaged accounts. They use tax-advantaged accounts before investing in taxable accounts.
For many high-income lawyers, every dollar put into a tax-advantaged account saves around $0.40 in taxes. Because a lawyer’s marginal tax rate is always higher than his effective tax rate, by contributing to retirement accounts he can save his marginal tax rate today and pay his effective tax rate tomorrow in retirement. This tax arbitrage will add thousands of dollars to your savings.
What types of tax-advantaged accounts are available? Start with a 401K. Then learn about Backdoor IRAs. Once those are funded, max out your Stealth IRA (HSA). Then read a book about taxes. Once you have a basic tax understanding, you realize that it’s more important to change your tax behavior throughout the year than it is to focus on taxes on April 15th. Planning your tax strategy for next year will likely save you thousands of dollars.
Keep in mind that you don’t have to learn the entire tax code. All you need to understand is the tax code that’s relevant to you. Luckily, that’s a significantly smaller part of the overall tax code. If you learn only a couple of things a year, but the time you’re five years out of law school you’ll be a tax master.
5. Poor Debt Management
It’s no secret that many lawyers graduate law school with substantial debt.
Often, poor debt management begins during undergraduate years and compounds during law school. I’ve been there. Law school debt is funny money and it’s easier to spend it than when you incurred your first $1,000 of credit card debt.
For new lawyers, the debt manifests in student loan debt, credit card debt, vacation debt and sometimes mortgage debt. The cumulative interest paid on these debt becomes a major financial drag. The truth: your debt works harder than you. It’s working 24/7 and 365 days a year generating interest that you have to pay back. The sooner you destroy it, the better.
Earlier in your career, you’re likely to be overwhelmed by many competing demands, such that it’s easy to put things on auto-pilot (like your student loans).
If you’re planning on paying off your student loans (i.e. not pursuing student loan forgiveness through a plan like PSLF or IBR/REPAYE), refinancing your students loans is a no brainer. You’ll save tens of thousands of dollars.
Holding a $150,000 debt at 6.8% a year generates a staggering $10,200 in yearly interest. Cutting that rate to 3.4% will save you $5,100 a year. That’s a hard return to beat for a few hours of work.
I’ve negotiated cashback bonuses with the student loan refinancing companies, so that you can get a bonus and pay off your student loans even quicker.
6. Investing Too Aggressively or Too Conservatively
In 2008, hedge fund manager Ted Seides made a $1 million bet with Warren Buffett on whether the S&P index fund would beat a portfolio of hedge funds over the next ten years.
How’s the bet going?
Warren Buffett has consistently advised making monthly investments in a low-cost index fund. On page 20 of his 2013 letter to Berkshrire shareholders, he writes:
My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
Because lawyers start careers later in life, there can be pressure to be overly aggressive with investments. This is foolhardy.
The greatest portfolio returns are achieved by matching the market returns through a low-cost index fund. It’s a counterintuitive proposal that the best return is to be as close as possible to average but it’s a proposal that has borne out time and time again.
As Vanguard founder Jack Bogle said, we are collectively the entire market anyway. Splitting the returns between you and the “helpers” just leads to lower returns for you.
This may be hard to accept. Lawyers might think that they are smarter than the general population, so it’s reasonable to think they can beat the market. But, financial professionals themselves cannot beat the market (as evidenced by Warren Buffett’s $1M bet). It’s too risky, too complicated and too much trouble to try and select winning investments. Take a billionaire’s advice. He probably knows what he’s talking about.
Plus, while you’re building wealth, the most important number is your savings rate anyway. Too many people are focused on chasing returns when they barely have any assets anyway.
7. Not Knowing How to Get Rich
It turns out that living below your means is the only way to build wealth. Building wealth has two variables: income and expenses.
Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery. – Wilkins Micawber from David Copperfield.
Most Biglaw associates have a fixed income. Make sure you qualify for the annual bonus, but otherwise, your salary is set and so there is not much you can do to increase income. However, you have great control over your expenses. Focus on increasing your savings rate. Related: See my sample 1st Year Biglaw Associate Budget.
8. Not Having a Written Financial Plan
An Investment Policy Statement (IPS) is a statement that defines general investment goals and objectives. It describes the strategies that used to meet these objectives and contains specific information on subjects such as asset allocation, tax rates and financial goals. Having an IPS provides the foundation for all future investment decisions made by an investor and serves as a guidepost for your financial goals.
Your IPS need not be complicated or lengthy. An IPS can easily be 2-3 pages. If you do not have a written policy, day-to-day events will influence your financial decisions. This leads to chasing short-term performance that will impact your long-term goals.
Your IPS will be a short document answering basic questions like:
- Where are your financial assets located?
- How much is in tax-advantaged accounts versus taxable accounts?
- How much will you be contributing to these accounts?
- What are your short-term and long-term financial goals?
- What asset classes will you use to meet these goals?
- What is your effective tax rate?
- What type of insurance policies do you have and what type of coverage do they provide?
9. Expensive Investments
The price you pay for investment advice has a significant impact on your overall wealth.
Many mutual funds charge an expense ratio for investing in their fund. If your fund has an expense ratio of 1%, then that means that for every $10,000 you have invested, the fund will take $100 each year to cover its expenses (regardless of whether the fund makes or loses money during the year).
Rather than debiting this money from your account, the expense ratio is baked into the fund’s annual returns. If your fund returns 4% over the year, the real return was 5% minus the 1% expense ratio.
As you can see, a 1% expense ratio may not sound like much but can be quite expensive. In the above example, a 1% expense ratio represented 20% of your total gains for the year paid over to the fund manager!
10. Assuming You’ll Have More Money in the Future
Lawyer salaries are weird. Biglaw associates are promoted each calendar year automatically and receive a corresponding salary increase. There are no opportunities to negotiate the raises, yet you know in advance your salary for the next year.
It makes it easy to assume that you’ll always be making more money in the future, which allows you to artificially inflate your lifestyle now. It also makes it easy to put off saving.
Yet at the same time many Biglaw associates do not know if they will be employed at a firm within five years. Many lawyers leave during their 3rd or 4th year (my assumption is that the large salary increase from a third to fourth year associate is an attempt by firms to retain associates during those years).
The reality is that outside of law firms there are no guaranties for large salary increases each year. Therefore, it seems much better to assume your salary is fixed and simply bank the raises. This helps you grow into your lifestyle slowly.
After all, making even $100,000 straight out of school is a huge windfall. If you set your salary at the latest biglaw salary scale, you will be able to save a substantial sum of money as your salary increases.
11. Buying a House/Apartment
Many Biglaw associates live in high cost of living locations. Therefore, they may be less likely to buy an apartment or home than a doctor living in Kansas. Still, many associates focus on purchasing real estate early in their career. The prevailing notion that “you’re throwing your money away on rent” is prevalent. But it doesn’t always work out well.
It may be easy to make a profit on the sale of a home, but lose money overall. This is because the cost of owning a home is high and often not included in the calculation when someone casually mentions that they “bought a condo for $600,000 and sold it four years later for $700,000”.
Plus, investments tend to go up as well. The person who bought a condo for $300,000 twenty years ago and sold it for $1,200,000 sounds like a genius but probably would have done better in the stock market with index funds.
Also, consider the outcome if you had bought a condo in NYC in 2006 right before the Great Recession. A lot of lawyers lost a ton of money during that time. If you’re considering purchasing a home, make sure to run your numbers through The New York Times Rent vs Buy Calculator.
What do you think? Have you made any of these mistakes? I know I’ve made several. Let us know what you think in the comments.