Case Study 6: Helping an ill and elderly parent

mother and adult childern

(Not actually Colin, his mother or sister)

Courtesy of Visual Photos

In today’s Case Study reader Colin offers us a chance to take a look at a tough situation many us have had or will have to deal with at some point. Many years ago, I did myself and with a situation eerily similar to Colin’s. His mother is sadly facing a serious illness and, with his help, is sorting thru a mix of investments that appear to have been chosen for the benefit of those selling them.

In this study we’ll see another example of why I don’t like investment advisors and we’ll examine some steps Colin can take to help his mother escape.

While I have already responded to Colin in Ask jlcollinsnh, it occurred to me this is a case that deserves wider readership. Many of you might benefit from the conversation and others might well have useful suggestions for Colin as well. If you do, I hope you’ll add your thoughts in the comments.

Here is Colin’s note:

I recently started reading your blog and I really enjoy all the great articles and advice.

I’m fairly confident when it comes to my own current investments, but I’d like to help my mother get her affairs in order and although I have ideas I’m a bit overwhelmed. I currently live in Germany so I’m somewhat limited with some of the help I can offer when I’m not in the US. I’m currently back in the US through the first week of January.

She was recently diagnosed with two types of cancer. One is a slow moving lymphoma and the other is squamous cell lung cancer which is large cell and less lethal than small cell lung cancer. She thought she was going to have surgery this week to remove a lobe of her lung but the date was moved to February. I came home with the intention to help her with her recovery but now that we have more time and energy I decided with her consent to help her get her home and finances in order.

My mother will be 65 in March and is retired. She receives $1,200 a month from social security. She has $40,000 in investments with Edward Jones of which $30,000 are in a taxable account and $10,000 are in an IRA. I was fairly shocked when I looked at what the taxable account is comprised of:

  • Freeport-McMoran Copper & Gold – FCX $13,876
  • Dawson Geophysical Co – DWSN $6,464
  • Broadcom Corp – BRCM $720
  • Patriot Coal Corp – PCXCQ $42
  • Hartford Balanced Income Fund C – HBLCX $11,071

The individual stocks are all holdover investments from a previous advisor at a different company my mother used.

I asked why no one at Edward Jones had sold the stocks as it is obviously very risky to have so much of ones money invested so narrowly especially at her age. She said that her current advisor wants to sell them but is waiting for the right time. That statement is a red flag to me. My mother did ask the advisor to take a small amount of her money and invest it aggressively.

I’d like to sell all of these stocks and the mutual fund and move most the money into Vanguard Total Bond Market with a small amount in Vanguard Total Stock Market and either a savings account, money market, or cd.

I know bonds are generally placed in tax deferred accounts but her income is so low I think her taxes would be minimal. Patriot Coal Corp is in the process of declaring bankruptcy and I was thinking it may be possible to use some of the capital losses to offset any capital gains. I’m not sure how bankruptcy affects selling stock. I realize that the stock may just be a total loss.

I think my mother would possibly like to stay with Edward Jones as they offer face to face advice (although I’m skeptical of the quality of it). I’m not sure if it would be possible to buy the Vanguard funds through EJ.

Would it be better to wait until the new year to put off paying taxes on the sale of the investments until the next tax year? I believe the Hartford Balanced Income Fund has a deferred load of 1% so I should probably read more about possible costs of selling it. If I transfer the investments to Vanguard from what I’ve read it would be better to transfer them in kind but I’m not sure all that implies.

Her IRA consists of:

  • Franklin Income Fund A – FKINX $4,240
  • Income Fund of American Fund A – AMECX $3,700
  • Lord Abbett Short Duration Income Fund A – LALDX $2,467

I’m slightly less concerned with these investments, but I’m nervous about how heavily they are invested in junk bonds. I didn’t know that mutual funds existed that would invest in dividend paying large cap stocks along with junk bonds. It is an interesting idea but seems overly complicated and risky. I would probably like to move these investments to Vanguard and place them all in Total Bond Market.

English cottage

Courtesy of Lilac  & Lavender

She owns her home with no mortgage in West Virginia on 60 acres in a rural area. Overall the house is in good shape but could use some repairs to plumbing and eventually will need a new roof. I’m sure other expenses will come up as often happens in life. The value is in the range of 80 to 100k. She has no desire or plans to move.

I think a possible asset allocation would be 70% Total Bond Market, 20% Total Stock Market, and 10% mix of savings account, cds, and money market. I like the Total International Stock fund as well (I own some in my AA) but it seems more volatile than is necessary.

She has a life expectancy as little as one year but possibly ten or more. It is really hard to tell at the moment. Besides the cancer she is very healthy and active. She will probably know more after her surgery in February but even then it is very uncertain.

I think it makes sense to have her assets as stable as possible so she can access the money as needed to make larger purchases for car and home repair.

My mother has a will and living will already. My sister and I are her only heirs and we are close and generally agree on how to proceed with all of these issues. My mother seems hesitant to spend the money to go to an estate lawyer but I think it would be good to go to see her options to protect her remaining assets and especially her home from medical debt.

I’m not concerned with inheriting the house or money but I also don’t want her to have to sign it over to the bank or hospital (she doesn’t either). She has been receiving a very generous amount of charity aid from the two hospitals she has been going to but the she has to reapply every six months. Currently she receives a 75% discount from one and a 100% from another. This won’t cover certain doctor’s fees though. She will have Medicaid until Medicare starts the month before she turns 65.

In your opinion does my mother have enough assets to warrant going to an estate lawyer?

It isn’t easy for me to make decisions with someone else’s money, but I don’t feel that my mother’s money is being handled appropriately.

I’ve read quite a few investment books at this point, but I have limited knowledge about issues she is facing. I’d hate to have someone from Edward Jones sell her another front load mutual fund with high fees and costs. I also don’t want her to lose her house. I know the decisions I make are ultimately my own and my responsibility but any advice would be greatly appreciated.

Thank you for your time,

Colin

And my reply:

Hi Colin…

I am very sorry to hear of the challenges your mother is facing with her health and finances. She is fortunate to have you there to help sort thru it all. And it is very fortunate she is open to your help and that you and your sister are on the same page.

You don’t mention what her annual expenses are, but I’m guessing she gets by on the $1200 from Social Security. I’m also going to assume you and your sister are willing and able to kick in to help support her if needed. This will play a role in the idea I’ll be suggesting at the end of this reply.

I am concerned that your mother asked the advisor to take a portion of her money to “invest aggressively.” This is the last thing someone her age and with her limited resources should be doing. Hopefully the advisor was honest enough not to take advantage of that request, but typically that’s like providing chum to sharks. In any event make sure it is off the table.

jaws

You are right to be concerned about her assets being in individual stocks and the advisor wanting to wait to “sell at the right time.” My guess is that this means some, in not all, are trading at a loss. It is foolish to hold on to these hoping for better days.

I agree with your plan to sell them all and redeploy the money at Vanguard in the Total Stock and Total Bond Funds. It is also a good idea to hold some cash for the house and car repairs you foresee. You are correct in that, at her income level, taxes are not much of a concern.

You should be able to sell the shares in the bankrupt company, but of course not for much.

It might be possible to buy the Vanguard funds thru Edward Jones (EJ), but why? You want to take all this and the IRA money out of EJ. Looking at what they have her in, the last thing your mother needs is more free advice from them. Clearly, these investments were made to benefit the broker, not your mother.

Likewise, roll the IRA into Vanguard. You can call Vanguard and they can help with the process. Don’t be surprised if EJ drags their feet and otherwise makes this difficult. It happens all too often. They don’t like seeing the gravy train head out the door.

Since your mother has minimal tax concerns, with the taxable account the easiest thing to do is have EJ sell everything and send her a check. She owes them no explanation. You could also do this with the IRA but you’d have to be sure to reinvest it in the Vanguard IRA within 60 days to avoid any taxes. But again, not a big deal for her.

Since we are near year end and just to spread the tax liabilities a bit, assuming there are capital gains in those stocks (and if not, no tax worries at all), you can sell the taxable stuff this year.

Then in January move the IRA to Vanguard and convert it to a Roth. Theoretically this will be taxable, but again in your mother’s situation a non-event. Once there, she’ll never have to pay tax on any withdrawals from it. Plus the Roth is much more advantageous to you and your sister should you inherit it.

Be sure she lists you as beneficiaries on all these accounts. This avoids probate and insures it passes seamlessly to you. Same with the taxable stuff.

And no, your mother doesn’t have enough assets to need an estate lawyer, but be sure her will is up to date.

As for the house, it sounds like that is where she is most comfortable and since she’s been there awhile and it is mortgage free I see no reason she shouldn’t stay as long as she is physically able.

My guess is that you might get some push back from her on leaving EJ. Sounds like she enjoys the interaction. But she is paying too steep a price. Here’s an alternative that would serve her better.

If you look at the right hand column here on the blog you’ll see an ad for Betterment. In the next few days I should have a post up recommending these guys. Not quite as cheap as DIY with Vanguard, they do provide an exceedingly simple way to invest in a portfolio of index funds. Rather than choosing the funds yourself, you open an account and tell them your goals. The software then suggests the asset allocations to reach those goals. Very simple and effective, and maybe just the level of involvement that your mother will enjoy with out the risk of expensive mistakes or her being sold high-profit-for-the-broker crap.

You mention a concern about losing the house to medical debt, but it is unclear in your comment whether she has that debt now or is concerned she might in the future. Regardless, she might want to consider moving some of her assets to you and your sister, and this is the idea I referred to in the beginning of my reply.

The IRS allows your mother to gift you and your sister each $14,000 with no tax consequences to you or her. If she can get comfortable with the idea, it would effectively take her taxable account from 30K to 6k. Less worry for her and possibly helpful in insuring the charitable benefits she now enjoys. Of course, if the time comes when she needs the money, you and your sister must be prepared to channel it back to her.

Hope this helps. Good luck to you and all the best to your mom!

Addendum #1:

Second thoughts on having mom gift money. From aspiringyogini in the comments below:

“I’m glad to hear that you will be talking to an elder care lawyer. We have consulted one too and have had good results. Your lawyer will very likely urge your mother to NOT give you money, just in case she needs long term nursing care and might need to qualify for Medicaid to get coverage. In order to qualify there is a 60 month look back period and if she has given money to her kids, then she would not qualify. This website echoes that and our elder care lawyer confirmed it too:http://www.elderlawanswers.com/how-gifts-can-affect-medicaid-eligibility-10006

Addendum #2: 

Also see Prob8′s detailed comment below. He is the author of this guest post:  Death, Taxes, Estate Plans, Probate and Prob8.

 More Case Studies

Posted in Case Studies | 25 Responses

Stocks — Part XX: Early Retirement Withdrawal Strategies and Roth Conversion Ladders from a Mad Fientist

Einstien

Albert Einstein in fine form

I like smart people.

People who can make me sit back and think, Mmmm. I never thought of that. Or I never thought of that in quite that way.

In most fields where I have a lay interest, physics or anthropology or evolution or psychology for example, this is not all that hard to do. My knowledge level is modest and my learning curve in the early stages.

With investing, not so much.

I’ve been working thru my understanding of money, how to think about it and how to use it for decades. You’d be hard pressed to think of a mistake I haven’t made. When I read the arguments against the validity of index investing, for instance, it is my own voice I hear in my head.

So it is not often these days I find a writer who truly expands my financial horizons. Someone so clear and insightful that when we disagree I find myself re-evaluating my thinking. But what a thrill when I do.

If you are a regular here, you may well already be familiar with The Mad Fientist. So impressed have I been, that I’ve fallen into the habit of routinely referring to his ideas and linking to his posts. I have even on occasion, and it is hard to fully express how rare this is for me, submitted my draft posts to him for peer review.

The most notable of these was my rant: Should you avoid your company’s 401k plan?

Offended deeply by the egregious fees many 401k plans have begun to charge, I dearly wanted to be able to tell you to simply skip these plans. Doing so would have appealed to my sense of justice and my appreciation of simplicity. But the facts lead to a different conclusion and at my request in Addendum I MF laid out the case for the value 401k plans provide even with their ugly fees. He was, of course, correct.

In many ways, that addendum was the precursor to this Guest Post.

Some of the more frequent questions I’ve been getting of late relate to how best, exactly, to begin pulling the 4% once retirement is reached. A major concern, especially for those retiring well before age 59.5, is how to access all those tax advantaged accounts without penalty. MF has it figured out and shares it right now, right here.

(I’ll also be writing more on Pulling the 4% in the future.)

If you are not already a MF reader, consider this a taste. For those serious about investing, my guess is you’ll shortly be as big a fan as I.

And if as you read his stuff you find an idea or two that conflicts with my own, it just might be possible he is the one who is right.

So now…

From the Mad Fientist:

Mad_scientist

Taxable vs. Tax-Advantaged

For investors, there is a recurring debate over whether to invest in taxable accounts or tax-advantaged accounts and how much to allocate between the two.

Taxable accounts are great because you can access your money at any time and you don’t have to worry about the government charging you any fees to do so.

Tax-advantaged accounts, on the other hand, allow you to reduce your taxes, thereby allowing you to invest more, but there are rules that govern how you access your money (for more info on the various types of “buckets”, check out Jim’s excellent post here).

Obviously, if you plan on retiring early, you’ll need to have access to a certain amount of money prior to standard retirement age so the debate is particularly heated within early retirement circles.

I’d say though, that not only is there a clear winner in this debate, it is even clearer for those aspiring to retire early. Winner: Tax-advantaged.

Tax-Advantaged Accounts

The main reason tax-advantaged accounts are usually best is because they allow you to put more of your money to work for longer. By investing the money you save on income tax, you can dramatically increase your savings rate and build up your FU money quicker.

Over on my site, I wrote an article titled Retire Even Earlier Without Earning More or Spending Less and in that post, I compared two different scenarios (see graph from the post below).

In the first scenario, a person who starts with nothing, makes $60K per year, spends $16,800 per year ($1,400 per month) and invests the rest in a taxable account is able to retire in just under 11 years (assuming a 5% real rate of return).

In the second scenario, I used exactly the same numbers but rather than only invest in taxable accounts, the person instead maxes out his tax-advantaged accounts (i.e. IRA, 401(k) with 5% employer match, and HSA) and invests what’s left in a taxable account.

This one minor, seemingly insignificant change results in shaving over two years off of his working career! That means, without earning any more, spending any less, or taking on any additional risk, he was able to reduce an already short working career by nearly 20%!

Retire Earlier Without Earning More or Spending Less

In this chart…

  • The dark green line represents the first scenario, using taxable accounts only.
  • The bars represent the second scenario, using maxed-out retirement accounts (the light green portion) and taxable accounts (the dark green portion).
  • The dashed red line represents how much he needs to be financially independent.

By utilizing his tax-advantaged accounts, he is able to reduce his taxable income from $60k to under $34k and therefore reduce his federal income tax burden by over $5,000 per year. As you can see in the graph, the additional tax savings that he is able to invest every year, when combined with the employer 5% 401(k) match, really adds up!

Now while it’s obviously beneficial to utilize tax-advantaged accounts, you may be wondering how you can access the money you contribute to the accounts before the standard 59.5 retirement age without being penalized.

Roth IRA Conversion Ladder

The best strategy, in my opinion, is to build a Roth IRA Conversion Ladder.

Here’s how it works…

Assume our example early retiree maxed out all of his tax-advantaged accounts during his working career and now has large amount of money in his 401(k) and Traditional IRA when he retires early at age 39.

Once he quits his job, the first step to accessing this money early is to move the 401(k) funds into his Traditional IRA. This step is the easy part and according to Vanguard, the rollover can be set up in about 20-30 minutes (although it may take 2-3 weeks to be processed).

After rolling over his 401(k) to his Traditional IRA, he can now start building a Roth conversion ladder.

The IRS rules state that you are able to convert a Traditional IRA to a Roth IRA, as long as you pay ordinary income tax on the conversion. It’s possible though, due to a low amount of income during early retirement, that he won’t have to pay any tax at all on the conversion. If the conversions are tax free, that means he will have avoided paying any tax on the money (tax-free contributions to 401(k)/Traditional IRA, tax-free growth within the retirement accounts, tax-free conversion from 401(k)/Traditional IRA to a Roth IRA, and tax-free distributions from the Roth)!

Assume for this scenario that he is confortable paying a few hundred dollars in tax each year for the conversion so he decides to convert $12,800 each year to cover over 75% of his $16,800 worth of annual expenses during early retirement.

Once the money has been converted into a Roth IRA, the converted amount is then available for withdrawal, tax and penalty free, five years after the conversion date (the earnings on those investments, however, need to remain invested until standard retirement age).

To build up his $12,800 conversion ladder, he moves $12,800 from his Traditional IRA to his Roth IRA every year. After the fifth year, he is then able to withdraw $12,800 per year from the account. Assuming he continues to convert $12,800 every year, he will be able to withdraw $12,800 from his Roth IRA, tax and penalty free, every year for the rest of his life.

It should be noted that since he won’t be able to access his retirement account money during the five years he is building up the conversion ladder, he’ll need enough in his taxable accounts to sustain himself for those years. Luckily, he ends up with over $100,000 in his taxable account (see the age 39 dark green taxable bar in the 1st chart) in this example scenario so he’ll be able to live off of that money until he is able to access the funds in his Roth IRA.

Here’s a graph to illustrate what the Roth IRA in this example would look like when building up the conversion ladder:

Roth IRA Conversion Ladder

Since you can build as big or as small of a conversion ladder as you want, you could potentially fund the majority of your early retirement using this strategy.

Substantially Equal Periodic Payments*

While the Roth IRA Conversion Ladder strategy is the method I plan on using to access my retirement account money before standard retirement age, there is another method that is worth mentioning.

It is possible to withdraw money from an IRA before standard retirement age, without penalty, by setting up a withdrawal schedule of Substantially Equal Periodic Payments (SEPP).

There are different ways you can calculate your periodic payments but the general idea is that you are able to withdraw a small percentage of your overall IRA balance every month, quarter, or year.

The downside to this strategy is that you would need to continue the periodic payments for five years or until you turn 59.5, whichever is later. If, for some reason, you stop your disbursements before the time restriction is up, you would be responsible for paying a 10% penalty on all of your periodic payments.

For more information on this strategy, check out the IRS FAQ on the topic.

I won’t be utilizing this method because 1) it seems much more complicated than the conversion ladder strategy and would likely make tax time even less fun than it already is, 2) I don’t want to be forced to withdraw money from my IRA in years when I don’t need to, and 3) the conversion ladder strategy is more than sufficient on its own to get early access to retirement-account money so there is no reason to complicate things with another method.

Conclusion

Obviously each person’s situation is unique so you should run your own numbers before making any changes to your contributions.

For many people though, utilizing tax-advantaged retirement accounts could allow you to supercharge your savings rate by drastically reducing the amount of money you pay in taxes.

Since many early retirees will likely have a low amount of earned income over a larger portion of their adult lives (i.e. the years after retiring), it is possible to access the money in tax-advantaged accounts early without paying any penalties or taxes at all, making this strategy particularly useful for future early retirees wanting to achieve financial independence sooner.

The Mad Fientist writes about financial independence, early retirement, tax avoidance, travel hacking, and geographical arbitrage over at madfientist.com.

Here are two more related Mad Fientist posts:

 The Guinea Pig Update The Mad Fientist demonstrates theory put in to action

Roth IRA Horse Race How to supercharge your conversion ladder

jlcollinsnh again…

As I said at the very beginning, I like smart people. And the readers here certainly qualify as is reflected in both the calibre of their questions and of their answers. But I also know many blog readers tend to skip the comments section. That is a mistake around here:

*Addendum #1: Substantially Equal Periodic Payments (SEPP)

In the comments below reader Lucas has provided several detailed responses to some questions posed. Taken together they almost are a post on this subject themselves. Well worth a read if you are considering this option.

Addendum #2: Roth Withdrawal Rules Summarized

Reader TLV also added to the SEPP conversation in the comments. In addition he/she provided a nice explanation of the Roth withdrawal rules ending with this:

So, to summarize:
*Tax free: contributions any time, conversions after 5 years from conversion, earnings after 5 years from opening Roth IRA AND over 59 1/2.
*10% tax: Conversions within 5 years from conversion
*Income tax: Earnings before 59 1/2 but due to 72(t), education, or medical; earnings after 59 1/2 but within 5 years of opening Roth IRA
*Income tax + 10%: Earnings before 59 1/2 and not meeting any other exceptions.

 Addendum #3: Retirement Withdrawal Strategies by my pal Darrow is an excellent overview of some of the options and he includes his personal approach.

Addendum #4: Curious as to what your taxes might look like in retirement? While everybody’s situation will vary, here are two excellent posts from my pal Jeremy detailing his own tax strategy as he travels the world as an early retiree: Never pay taxes again and his actual 2013 tax return.

 

Posted in Guest Posts, Stock Investing Series | 76 Responses

Death, Taxes, Estate Plans, Probate and Prob8

 spiderman uncle

 “With great power comes great responsibility.”

      Spiderman’s dead Uncle Ben

(Oh, and some other guy named Voltaire.)

So, too, with wealth.

One of the pesky things that nobody ever seems to tell you while you are accumulating it, is that is that having and keeping it requires effort. You must learn how to invest it and how to protect it from the many forces that would happily pull it from your pocket into theirs. And this Great Responsibility of Wealth continues after you die. How unfair is that!?

But if you shirk this responsibility, your wealth will flee from you; while you are alive or after you are dead.

So far on this blog we’ve only talked about the alive part. This is not because I don’t think the death part is important. I very much do and in fact have had my own Will and other documents in place for many years.

Rather it is because I am not qualified to write about this stuff. While it might not always show, I try to write about only those things I actually understand. For this topic my knowledge base is simply too limited. For my own needs I have personally relied on legal professionals to get it done.

Early on a reader calling himself Prob8 began showing up on this blog. His comments were always well reasoned and well written. In my mind I heard his name as Prob(ably)8 and wondered, as I sometimes do with internet names, what it meant.

Back in October I finally had the chance to meet him while attending FinCon, the conference for financial bloggers like me. Turns out he is an attorney with a practice focused on estate planning and “probate” is the correct pronunciation of Prob8.

Regardless of the pronunciation, it didn’t take me long to figure out that in Prob8 I had just the right guy to fill in a knowledge gap around here for which my own abilities came up woefully short. He graciously agreed and here is his Guest Post. In an appropriately lawyerly fashion it begins with a disclaimer.

 Estate Planning Made Understandable

by Prob8

disclaimer

DISCLAIMER – You should contact a licensed professional to assist in the preparation of your estate plan.  This post and any comments are not legal advice and will not create an attorney-client relationship.  If you are not in the United States, this post may be useless to you and will probably suck to read.  You’ve been warned.

At some point in your life I suspect you will question whether you need an estate plan.  This may happen when someone you know dies, you reach a certain level of wealth, or perhaps when a friend or family member plants a seed in your mind.  For me, estate planning did not make it onto the “to do” list until my first child was born.

If you have not yet planned your estate, you might be wondering why you need to make a plan.  You probably don’t want to spend any more time than necessary in life with a lawyer.  You certainly don’t want to give them any of your hard-earned money.  I don’t blame you.  I feel the same way.

At a basic level, you need to make a plan in order to deal with incapacity during lifetime and distribution of your assets in an orderly fashion at your death.  But estate plans can accomplish much more than that.  Additional goals for many who plan their estate include avoiding the probate process (more on this later), reducing or eliminating estate tax (more later), creating creditor protection for heirs, and creating guardians for minor children.  Of course, this is not an exhaustive list and not all of these things will be relevant to you.  If some are relevant, you should give serious consideration to preparing or reviewing your plan.

Not everyone has an estate plan and that might get you thinking about whether there are alternatives to formal planning with a lawyer.  There are.  Let’s discuss some of them.

Informal Estate Planning

The first thing you need to know is that your state has an estate plan for you already in place.  The good news is that it’s free of charge and requires no formal documentation or effort on your part.  The bad news is that it probably doesn’t say what you want and relying on it will likely lead to increased costs and aggravation for your family.

1.  State Default Rules.

Let’s assume you have no formal documentation and your death occurs.  For simplicity, let’s also assume your assets are solely in your name with no co-owners or named beneficiaries.  Having failed to plan your estate, your family is now subject your state legislators’ opinions about how your assets should be distributed.  Perhaps you are okay with your state’s plan.  Perhaps not.  If you’re unsure, you should do some research.  You can start here (http://estate.findlaw.com/planning-an-estate/state-laws-estates-probate.html).

Example: Because I practice in Illinois (and because it’s the home of Jim’s alma mater) (jlc: Go Fighting Illini!), let’s assume you live here too.  Let’s also assume you have a spouse and an adult child.  At your death, Illinois law says your spouse would be entitled to the first $20,000.  After that, the net assets will be distributed 1/2 to your spouse and 1/2 to your child.  Is that what you intended?  I don’t know . . . you’re dead.  Unless your wife can channel your spirit through Oda Mae Brown*, I doubt we will ever know.  I can tell you that unless your family gets along really well, someone is probably going to be upset with that result.  Especially if this is a second marriage and the child is from a former marriage.

Death isn’t the only thing covered by your state’s default rules.  You’re also covered in the event you become incapacitated due to accident, illness or otherwise.  As with the death laws, the rules for handling your affairs while incapacitated vary from state to state.  In some cases, your spouse might be able to make limited medical decisions on your behalf.  More likely, some form of court proceeding (known as a “guardianship” in Illinois) will be required for making material and long-lasting medical decisions on your behalf.  Please note that relying on state default rules for incapacity will probably be time consuming and expensive.

When it comes to money, someone will almost certainly need a court proceeding to make financial decisions and pay bills on your behalf during your incapacity.  As you might imagine, involving money has a tendency to increase the contested nature of a court proceeding.  This is fine with me as a lawyer: It helps in my efforts to accumulate my own F-You Money.  It’s not so good for your efforts.

2.  Beneficiary/POD/TOD Planning.

A convenient and mostly free way to reduce some of the potential problems, costs and uncertainty of having no plan is to plan by use of beneficiary designations, pay-on-death (POD) designations and transfer-on-death (TOD) designations.  Making an account automatically pay to someone upon your death is as easy as completing a form provided by your bank, insurance company or other financial institution.  In some states (http://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter5-1.html), you can even name transfer-on-death beneficiaries with respect to certain types of real estate and even vehicles (http://www.nolo.com/legal-encyclopedia/naming-tod-beneficiary.html).

There are some benefits to this type of planning.  Being cheap and relatively easy is certainly a nice benefit.  Planning this way will also help you to avoid probate provided your beneficiaries outlive you.  Assets transferring in this fashion will generally not be subject to the claims of your creditors at death.  Also a very nice benefit.

Planning this way isn’t all sunshine and rainbows though.  First, this works for many mainstream assets like bank accounts, investment accounts, retirement accounts and life insurance.  It does not work so well for assets like small business/partnership interests, most personal property, and real estate in many states/instances.  This type of plan probably does not work well for parents with ankle-biters as they may receive their “inheritance” at the age of majority in your state.  Please note that to the extent you have (or later create) a Will, your POD/TOD/Beneficiary designations will take precedence over anything you say in that Will.

Also, you must be very careful about your financial institution’s default rules for what happens if a beneficiary (perhaps one of your children) does not survive you.  Does your institution pay to the surviving beneficiary or do they pay to the deceased beneficiary’s descendants?  If you plan this way, you must review the plan if a beneficiary dies before you.

A significant problem with this type of planning is that it does not deal with your incapacity.  If you become incapacitated while using this planning method you are stuck with the default (i.e. guardianship) rules we already covered.

For those of you with an estate large enough to trigger federal or state estate tax, this type of planning will do nothing to reduce that burden on your beneficiaries.

3.  Joint Ownership (with right of survivorship).

Owning assets jointly with someone else is another way to informally plan an estate.  Many of you probably already engage in this sort of planning by owning assets jointly with your spouse.  For jointly owned accounts, the death of one owner will automatically make the other person the sole owner – the Last Will and Testament of the first to die is irrelevant as to jointly owned assets.  Further, incapacity of one joint owner will allow the other joint owner to have full access.  Planning this way works well for real estate, financial institution accounts (except qualified accounts like IRA’s and 401k’s), and many forms of personal property.

While this works well for married couples, most people are reluctant to name their children as joint owners of their property (privacy and being subject to their children’s creditors are big reasons).  As a result, the death of the second joint owner will result in probate unless other steps are taken.  If you have an estate tax problem, planning this way may not be your best bet.  Of course, this planning method needs to be combined with something more to deal with incapacity of both owners or the surviving owner.

Formal Estate Planning

While informal planning may work in some cases, it comes with gaps that need to be filled.  That’s where formal estate planning comes in.  Every plan should consist of a minimum set of documents**.  Here they are and what they do (at a very basic level):

A.  Last Will and Testament.

Although a Will can accomplish many tasks, the primary one is to direct the disposition of your assets at your death.  For parents with underage children, Wills can often be used to designate who will raise your children and how/when their inheritance will be distributed.  The issue of guardianship for minors is probably the most common reason I see for people making their first estate plan.

Although a Will is an essential component of every formal estate plan, it not the most effective tool for dealing with two of the other very common reasons people make a plan – probate avoidance and estate tax reduction/elimination.  Since the term “probate” is such a big concern for many people, let’s take a minute to discuss what it is and why a Will can’t help you avoid it.

Probate

Probate is the process of validating your Will at your death, ensuring your valid debts and expenses are paid and distributing your net estate in the manner you direct (with limitations).  While many people believe having a Will avoids the probate process, quite the opposite is true.  In order for your Will to be validated, it must be filed in court and a judge must say it meets all the technical requirements in your state – an essential element of the probate process.  If it fails to meet those requirements, your Will is invalid and your estate will be administered in accordance with the state default rules mentioned above.

There are many reasons people don’t want their estates to go through probate.  The three most common are:  1. the probate process is very public – your Will, heirs, asset information, etc. are all open to inspection by anyone who wants to look; 2. the probate process takes a relatively long time to complete (varies by state) which tends to tie up your assets; and 3. the probate process can be expensive.  If you want to know more about probate, this should get you started: http://legal-dictionary.thefreedictionary.com/probate

You should note that only those assets owned by you in your individual name are subject to probate.  Anything with a beneficiary, TOD/POD or jointly owned (with right of survivorship) will bypass the probate process.  Further, small estates may not need to be probated.  The definition of a small estate varies across the country – see here to check your state’s rules. (http://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter8-2.html)

B.  Power of Attorney for Healthcare.

This document is primarily designed to appoint an agent to make medical decisions on your behalf if you are incapacitated.  Without this document, a court proceeding will typically be required to give someone the legal authority to act on your behalf.  This document typically begins upon signing and terminates at your death.  If your state requires certain language to be “durable” (i.e. survives your incapacity), you must make sure that language is incorporated.

C.  Power of Attorney for Property.

This document allows an agent to manage your business and financial affairs.  As with the healthcare power of attorney, failing to have this document will likely result in a court proceeding to allow someone to pay your bills, manage investments, and do all things asset related.  Your agent’s powers typically begin upon signing and end at your death.  If you are uncomfortable giving your agent that level of immediate power, you may want to consider making the document effective upon the happening of some future event (e.g. your incapacity).  Again, don’t forget to include durability language if required by your state.

D.  Living Will.

Although included in the basic set of documents list, this document is considered optional to many people.  The document is designed to deal with the specific issue of end-of-life care (e.g. life support machines).  If your healthcare power of attorney is broad enough to adequately cover life support machines and end-of-life care, you can consider skipping this document.  However, if you would like to give your agent and family specific instructions for end-of-life care a living will should be considered.  If you aren’t sure whether to include it, do a little research on living wills in your state.  Here is Illinois’ form document to give you a flavor for what one says.  http://www.state.il.us/aging/1news_pubs/publications/poa_will.pdf

As mentioned, using a Will as your primary post-death planning tool will leave a couple significant gaps – requiring probate and failing to efficiently deal with estate tax.  If these issues are a concern for you, the following additional document should be considered:

E.  Revocable Living Trust.

A revocable living trust is a document you create during your lifetime to hold your assets.  You are typically the trustee of the trust during your lifetime which ensures that you maintain full control of the trust assets.  If properly used, this document will become the primary vehicle to manage your assets both during your lifetime (even during incapacity) and at your death.  Once an asset is transferred to your trust, you technically no longer own it.  Instead, your trust owns the asset and you are merely the trustee.  This is the reason any assets transferred to your trust avoid probate – remember, only assets you own in your individual name at death are subject to probate.  If you own real estate in multiple states, a trust is a great way to avoid having to probate your estate in each jurisdiction.

Estate Taxes.

If you are married, a properly prepared estate plan using trusts can reduce and often eliminate the need for your heirs to pay estate tax.  Before you prepare a plan to deal with estate tax issues, you must first determine if you have an estate tax problem – most people don’t.  If your estate is less than $5,250,000 (2013 exemption amount which will adjust over time), no federal estate tax will be due at your death.  If you are married, you can pass up to $10,500,000 to the next generation without triggering estate tax by filing the proper documents at the first spouse’s death.  Please note, your “estate” consists of anything in which you had an ownership interest at the time of your death including jointly owned accounts, accounts where you’ve named a beneficiary, IRA’s, 401k’s, life insurance, etc.  I bet life insurance surprised you.  Although the benefits are generally not income taxable to the beneficiary, they are counted in your gross estate for estate tax purposes.  For more detail, see here  http://www.investopedia.com/ask/answers/09/life-insurance-tax.asp

Even if you don’t have a federal estate tax problem, you must also determine whether you have a state estate tax issue.  Some states collect estate tax while others don’t.  If your state collects the tax, the exemption amounts are going to be lower than the federal government.  To see your state’s rules, start your research here  http://wills.about.com/od/stateestatetaxes/qt/nostateestatetaxes.htm

A final note on estate tax . . . you can pass an unlimited amount to your spouse at death.  If you are single with an estate above the state or federal exemption amounts, there are solutions but you’ll need to get more creative.

DIY Planning.

I suspect many of you are like me and enjoy doing things yourself – both for the joy of accomplishment and for the money savings.  If you plan on doing your own estate plan be very careful.  I have been practicing law for more than a decade – in the estate planning arena for most of that time.  In that time, I have administered several DIY Wills.  None of them accomplished what the testator intended.  Many had fatal flaws leading to their outright rejection in court.  All of them led to above-normal administration costs.

This biggest problem I have with DIY planning is that problems are often not discovered until it’s too late.  It’s not like improperly fixing a leaking faucet.  If you mess that up, you’ll know.  You can always try again or call a professional.  Estate planning documents are a bit different.  You may not know there’s a problem.  If there is a problem, you’re probably already dead or incapacitated and can’t fix it.

If you decide to write your own, please at least consider having them reviewed by a professional.

 

* Bonus points if you know who that is without looking it up.

** Special circumstances may require additional documents.  Those circumstances and documents are beyond the scope of this post.

Note from jlc:

Prob8 practices law in Illinois. If you would like to talk to him about engaging his services, say so in the comments and I’ll connect you thru email.

Addendum: 

My pal Darrow just put up an excellent post on this stuff, too. It is especially worth reading if you are considering doing this as a DIY project: Do it yourself Estate Planning.

Addendum 2: Curious as to what your taxes might look like in retirement? While everybody’s situation will vary, here are two excellent posts from my pal Jeremy detailing his own tax strategy as he travels the world as an early retiree: Never pay taxes again and his actual 2013 tax return.

Posted in Guest Posts, Life | 34 Responses

Case Study #5: Zero to 2.6 million in 25 years

chau wine toastchau wine toast

In Case Study #4 we looked at reader EmJay’s potential transition from a current corporate career into a new life funded in part by his financial independence. A family man at age 48 and with 2.6 million in net worth, the conclusion was he easily had the resources to chart and enjoy this next, freer stage in his journey.

The longer I write this blog the more I am struck with the incredible range and diversity of the readers here. Very much as with the Chautauqua attendees described in A Week of Dreams.

This range is on best display in the comments, where readers ask questions and exchange ideas with me and each-other. For my money, some of the most interesting information is to be found in these conversations. The questions expand and clarify the topics the posts introduce.

But be that as it may, I am also aware that many blog readers skip reading this material all together. It is for this reason I occasionally move especially striking comment dialogs into the post as addendum. And it is how this follow-up Case Study came to be.

Not surprisingly, for those readers just starting their own financial journeys, there is a keen interest in what the path from Zero to 2.6 million in 25 short years actually looks like.

Reader Tom asked exactly that in Case Study #4′s comments and EmJay graciously provided a detailed reply. What is striking to me is how ordinary this path is.

Certainly EmJay and his wife had successful careers. But they also started out with quite modest incomes, elected give up one of those incomes to have a stay-at-home spouse once their son was born and there is a failed business venture in the mix. Yet, in the end, the results are very impressive.

So why is EmJay a multi-millionaire when just a few years ago the news programs were clogged with stories of other manager and executives a few short months from losing their houses? Here’s what jumped out at me:

  • EmJay and his wife married a bit later in life and after their careers were starting to roll.
  • They had their son after they had established some financial stability.
  • They share similar financial attitudes.
  • They stayed married. Perhaps those first three points helped?
  • They started investing early.
  • They maintained a high savings rate.
  • They learned from their mistakes and moved on.
  • They didn’t panic during the big crash of 2007-9.
  • They avoided lifestyle inflation.

That’s my take, anyway. Here’s what they both had to say in their own words. My editing reflects only formatting. Enjoy!

ask-question

This is actually not Tom.

From Tom:

Jim,

Thanks again for a great post! I stumbled across your blog earlier this summer and have spent the last few months catching up from the beginning, now if I could only get my parents and girlfriend to read the stock series!!

EmJay,

Question for you and any other readers for that matter.

I believe I’m one of the fairly younger readers here (25) and recently have gotten very serious about savings, cutting expenses as well as building my income (from work & recently, in 2013, attempting to find other ways – investing, etc.) As I have begun to do this, its apparent I missed out on a few things those initial years of working, maxing out 401K, investing my excess cash instead of letting it sit in a bank account, etc. With that in mind, I have made it a serious goal to grow my income as fast as possible, so the compounding effects will be felt later on.

Now for that question –(do not feel obligated if you would rather not share further details)

Through the course of your career, what is the level in which you achieved that income that would were satisfied, and knew could bring you to this end result? Based on your net worth it seems like you may have been making that salary over 100K for quite some time. Is this a level that you have just built up to over the course of your career? Or were there times that it was higher and you have adjusted/switched positions for lower salary as you became closer to FI?

I think this may be an interesting topic to look into and could greatly benefit the younger readers — What should be the typical growth of salary year by year (for your main source of income) to achieve these goals? Are we on the right track?

Best Regards & Thanks again,

Tom

making a point

And this is not actually EmJay.

EmJay replies:

Hi Tom,

If you are getting a start on developing a lot of the good habits identified on this and other similar forums at the age of 25, you are off to a good start and well ahead of most of your peers. You’ll also be well ahead of my schedule.

I’d say the only thing that I did right in the early stages of my career is put money in company 401K’s. I didn’t really get serious and smart about our investments until I was approaching 30.

If I would have had an information source and community such as this in my mid-20’s, I can only imagine how much earlier we would have achieved Financial Independence. There were definitely mistakes made along the journey.

You pose an interesting question. The most complete way that I can think of answering it is by walking you through my financial journey and some of the milestones along the way.

The vast majority of my career has been spent working in Corporate America and it has been a pretty steady and stable upward trajectory in my salary. Here’s an overview of my income and savings trajectory (to the best of my memory) starting with my first job out of college:

- I generally started with zero savings coming out of college but also had zero debt. My wife started an IRA while in college and also finished school without any debt. Major kudos to both sets of parents for helping us to get started without a mountain of debt.

Year 1:

My starting salary in my first job was $22K. (FYI – Based on an online inflation calendar that would be roughly equivalent to $43K in today’s dollars). Assume 4-7% annual salary increases until the next big job change. Started putting money into 401K right away.

Year 5:

Changed jobs/industries and my new salary was in the low $50’s plus a bonus plan.

Years 7-8 

(30’ish years old): Living together and then marriage, becoming DINK’ers (Double Income No Kids). Between both salaries, surpassing $100K for the first time.

We were saving about 40-50% of our joint take home pay while also contributing to 401K’s up to at least the company matching amount.

This was the time period where I ramped up my knowledge on investing. We started with a financial advisor for a year or two. After further educating myself on investing and realizing how much we were paying in fees and commissions, we ended our relationship with the advisor and decided we could do better on our own.

We also bought our first home for $180K. Started investing in Vanguard mutual funds around this time.

Year 11: 

Have first child. After working a part-time schedule for a year or two, my wife decides to be a full-time Mom. Back to living on one salary. My stand alone salary is in the low $90’s. Also start investing in 529 Plan.

Year 13/14:

This is about the time that my salary cracks $100K for the first time; saving rate of 30-35%; also start maxing out 401K each year based on govt. limits.

Year 15 +/-: 

First time that portfolio cracks $1,000,000. This is probably the first time that I’m thinking, WOW, I might be able to take an early exit from the work rat race if we can keep this up.

Year 16/17: 

Decide to pursue an Entrepreneurial opportunity. Make approximately $25k and zero savings during this time period. The opportunity didn’t work out as planned but no regrets in trying.

Year 18: 

Sell first house for $490K (the house we purchased 10 years earlier for $180K). Buy new home in the $500’s. Re-enter Corporate America with a salary of $120K; we continue on the one salary. I see annual increases in salary of 5% on average leading up to the present day.

Years 20-23: 

The dark days of the market. Our portfolio is roughly cut in half during this time period. I stay the investing course, do not withdraw from the market and continue with auto-investing into Vanguard Funds and 529 Plan each month. (jlc–emphasis mine)

Year 25/Present Day: 

Salary in the $160K range. Continue maxing out 401K and investing approx 30% of take home pay; wife has picked up some part-time work the past few years which pays peanuts but she enjoys it. The equivalent of all her income goes into an IRA for investment and tax deduction purposes. Also re-financed the home mortgage a couple of times over the past seven years.

Additional Income:

Throughout the course of my career, bonuses and stock options probably contributed another $200K of after tax income. I believe it is important to disclose this for a complete picture of our journey and some things that made our present day situation possible. Aside from using some of this income for home remodeling projects, the majority went directly into Savings.

Mistakes made along the way:

    • Used a Financial adviser for a couple of years; paid high fees and commissions
    • Purchased a lot of individual stocks along the way and still own many of them. Some did pretty well. But, many did not.

Things we did right along the way:

I’m not sure if it was an article here on Jim’s website (jlc–Yep: The Simple Path to Wealth, one of my earliest.) or another but somewhere along the way, I read that rule #1 on the path to Financial Independence is (assuming one marries) to make sure you pick a spouse with similar financial views. My wife and I have always shared similar values and beliefs when it comes to finances and our journey has been a true team effort.

Investing:

    • Since we’ve been married, we’ve been investing 30-50% of all take home pay per year.
    • We have stayed true to investing for the long haul and have not committed the common mistakes of buying high and selling low.
    • Discovered John Bogle, Vanguard, and Index funds fairly early in life.

Spending:

    • We have lived well below our means, especially as it relates to big ticket items such as home and cars
    • We drive our non-fancy cars forever
    • Hardly ever go out for dinner
    • Do a lot of our own home improvement projects
    • Always pack a lunch for work
    • Keep house temperatures low during the winter and high during the Summers
    • Use the dryer as little as possible
    • Some other frugalities

i-love-it-when-a-plan-comes-together

Final Thoughts:

We don’t lead a Spartan life by any means. We have a nice home, drive two cars, pay for Cable TV, have a calling/data plan that is more expensive than it should be, have some expensive hobbies/interests, etc.

But, we also have some frugal spending habits and have saved at a fairly good rate. There is no question that we can and will reduce our spending habits. I applaud those folks that are able to save 50-75% of their earnings, keep their expenses way down and achieve Financial Independence even earlier in life.

We took a less extreme path along the way than some others but have still been able to achieve a level of Financial Freedom that a majority of Americans will never achieve. I guess my point is that there are different ways in getting there and now you have a better picture of our journey.

Addendum: Can Everybody Really Retire a Millionaire?  

More Case Studies

Posted in Case Studies | 36 Responses

Case Study #4: Using the 4% rule and asset allocations.

asset allocation

Today’s Case Study gives us a chance to explore how to determine net worth and how to apply the 4% withdrawal rate against it. It also takes us into the arena of applied asset allocations.

Since this correspondence and its questions come from somebody with a high net worth, it also gives me a chance to share with you an asset allocation strategy I’ve been contemplating. It is a variation of the 50/25/25 model discussed here and here. We’ll do that at the end of the post.

But first, let’s read EmJay’s letter and answer his questions.

Hi Jim,

Let me begin by expressing my appreciation for all the time and energy you have devoted to providing the content on this website. I discovered both the MMM and your website just a few weeks ago and there has been a bit of an obsession consuming all the valuable information provided. Great stuff!

Let me fill you in on my situation and I’ll pose a few questions where I would greatly value your thoughts and input. If you don’t have the opportunity to respond, I totally understand as I’m sure you receive quite a few of these messages. If nothing else, my questions may provide some ideas for some future articles.

My wife and I are in our late 40’s and we have two early teen year children. My current take home income after taxes and 401K deductions (max) is approximately $120K.

Already a big fan of Vanguard, this is where we have all our savings/investments. However, our investments are spread over many mutual funds (combo of indexed and managed funds) as well as we own several stock purchases. I know what I need to do as far as re-allocation goes based on your series.

I believe we have achieved Financial Independence based on the 4% Rule (but this is the source for some of my questions that follow) and I’m ready to step away from my current job into semi-retirement as I explore possible 2nd career opportunities and other valuable ways to spend my time doing things that I enjoy.

Current State:
Annual Spend: $70K
We’re actually closer to $65K but through a combination of cost cuts that I know we can make while also accounting for an increase in our health insurance costs as we move off employer-provided coverage, I want to cautiously plan assuming an annual spend of $70K.

Savings:
Non-Retirement/Taxable Vanguard Accounts: $1.1 million
Retirement Vanguard Accounts: $900k
Total Savings: $2 million
Current Allocation is roughly 80% Stocks, 15% bonds, 5% cash

Additional Assets:
529 College Savings Plan for the kids – $250K (Note: Our State’s plan is run by Vanguard and has the lowest fees of any 529 Plan in the country)
Home Equity – $350K (still have about $150K left on our mortgage with 13 yrs remaining on our 15 yr loan @ 3.5%; $1400 monthly mortgage)

Questions:

1.  Am I able to include our Retirement Savings as part of the overall Financial Independence (4 % Rule) calculation? Or should I only be taking into account my assets in the Non-Retirement/Taxable accounts? I have seen some conflicting views on this point.

I’m 48 so I won’t be able to access my retirement accounts for another 11+ years. My thinking is that the Retirement funds continue to grow untouched while we live off the dividends and capital gains in the non-retirement/taxable account to cover our expenses in the interim. Make sense?

2.  Should one typically include their Home Equity as part of the 4% equation? I haven’t been and view it more as a surplus for the future if/when required.

3.  With our home equity, does it still make sense to also invest in the Vanguard REIT index if for no other reason than diversification of Real-Estate ownership?

4.  In doing the re-allocation of my many mutual funds to the select few index funds in my non-retirement account, will the capital gains on those funds that are moved to another fund be subject to Taxes? My understanding is yes which could have some bearing on when and how swiftly I do the re-allocation as I believe I could end up paying dearly in taxes.

5.  Should I go with the suggested 50/25/25 allocations in both the Taxable and Retirement accounts or would you suggest that I place my investments in the Vanguard REIT Index and Vanguard Total Bond Index in the Retirement Accounts only? (I seem to recall you making this suggestion elsewhere)

I’m close to being ready to pull the trigger on semi-retirement and financial freedom but need to have my ducks in a row to help get my wife totally on board and comfortable with some aspects.

I know more pay-checks will be in my future. I don’t know when, I don’t know what I’ll be doing and how much I’ll be doing it (full-time vs. part-time) but I want it to be on my terms. I haven’t experienced much work joy in my 25+ years of employment to date.

Thanks again for sharing your experiences and wisdom and for considering my questions.

walk_away

Walking thru the questions

My reply:

Hi EmJay…

Let me begin, in turn, by offering a hearty “Job well done!”

Based on the “4% Rule and your projected 70k annual spending rate, you are already comfortably well into Financial Independence (FI). At 4% that spending rate requires only 1.750 million and your net worth is around 2.6 million.

You have earned the financial right to do what ever you please. Plus you are entering an age where your time is far, far more valuable than adding more money to your stash.

Let’s walk thru your questions:

1. In thinking about the 4% rule, you should look at your total net worth. Tax-advantaged and Taxable accounts are simply the buckets in which you hold your investments. Based on your numbers, this gives you 2 million.

You are correct to think about them separately when it comes to withdrawals. The taxable accounts will provide your living expenses until you hit 59.5 while the tax-advantaged accounts grow untouched.

2. Yep, your 350k home equity is also figured as part of your net worth. So now you are at 2.350 million. You can certainly view this as a surplus if you like and as you have. You might also just think about it as an extra cushion that puts your financial picture in an even more powerful position. At 70k your withdrawal rate has now dropped to only 3%. Sweet! And this will allow your stash to grow even more over the years you are retired.

Also consider that at 4% 2.350m throws off 94k:  24k more than your projected spending. While I wouldn’t suggest you ramp up your spending to this level, you should be aware that you have some “splurge money” if you so choose.

With a basic withdrawal rate of 3%, you could easily splurge once every couple of years. Maybe a big trip, maybe a new car, maybe a house remodel or maybe even your own charitable foundation.

3. Since your home equity is part of your net worth, you also use it in calculating your allocations. If you choose the 50/25/25 allocation I personally use, you’ll want 25% in real estate.

25% of 2.350m is 587.5k. Since you have 350k of this covered in your home equity, the balance of 237.5k would go into the REIT VGSLX.

While you didn’t ask, I’d also keep your 3.5% 150k mortgage. That’s a nice low rate and I see no need to pay it off early.

Let me also make the point here that when calculating the cost of owning a home, the opportunity cost of any equity should be included; the 350k in your case. For more on that, check out this post.

4. Yep. Anytime you sell shares in your taxable accounts it will be a taxable event. You’ll want to tread carefully here.

First, do as much of the re-allocation as you can using the tax-advantaged accounts.

Second, consider you might be better off just holding the funds you have rather than taking the tax hit.

Third, if you have losses in any of these investments you can harvest them to offset the gains as you re-allocate.

Fourth, since your living expenses will be coming from these funds, by carefully selecting the order in which you draw from them you can slowly and more tax efficiently reduce the number of funds you have while improving the overall quality of your remaining holdings.

5. As a general rule you should keep the investments that pay dividends and interest in your tax-advantaged accounts. Stock index funds are inherently “tax-efficient” and so are the better choice for taxable accounts. Of course these are fine in tax-advantaged accounts too.

Once you retire and your income drops this will be less of a concern. Even with your net worth, your taxable investment income still should leave you well under the 15% tax bracket ceiling. Keep in mind any income from your new activities could alter this.

Next under the category of “You didn’t ask but…”

…let’s turn our attention to the 250k in the 529 plans for your kids. Not much to say. You’ve got it well invested. (I’m guessing Utah is your state?)

But careful readers will have noticed I included this 529 plan money in initially pegging your net worth at 2.6m. But then I went on to exclude it in the conversation on allocations and withdrawals. The reason is, this money is earmarked for a very specific goal. As such, I prefer to set it aside for these kinds of discussions.

Finally, you say: “I haven’t experienced much work joy in my 25+ years of employment to date.” You are not alone in that. But those days are about to be behind you and a long, bright future awaits.

 Freedom from chains

You’ve done a wonderful job in positioning yourself and your family for a path on your own terms. You’ve paid your dues and you deserve it.

Enjoy!

Allocation Variations

As mentioned at the beginning, I’ve been noodling some ideas on modifying the 50/25/25 allocation model for folks with a high net worth, high risk tolerance and an aggressive investing profile. For our  purposes here we’ll consider 2 million+ as high net worth.

This is an aggressive option to consider. It is for those who seek maximum growth and have maximum flexibility and the intestinal fortitude to accept the additional risk.

If we review the thinking behind the 50/25/25 stock/bond/real estate allocation, recall that stocks serve as our growth engine, bonds as our deflation hedge and REITs as our inflation hedge. The bonds and REITs also help smooth out the ride and provide a bit more dividend and interest income. But those are secondary benefits.

We are mostly using them to hedge against another deflationary Great Depression or a bout of hyper-inflation. Of course they also hedge against much more minor variations of these, too.

Now remember, if we start to see large deflationary or inflationary moves, our bonds or REIT investments will grow dramatically. That is, after all, the core idea: We have one asset class performing well even as the others suffer so we remain –relatively– fiscally healthy.

But how much do we really need? Once over 2 million in assets you are in pretty rarefied air. So maybe, just maybe, rather than percentages, total dollars in each asset could be the measure. This would cap the amount in bonds and REITs while letting the amount in the more powerful (and more risky) growth engine of stocks grow. With 2.350m it might look like this:

  • 500k in bonds (21%)
  • 500k in RE (21%)
  • 1350k in stocks (57%)

Of course the dollar amounts can be whatever best fits your risk tolerance and your desire for growth. You could, for instance, set the threshold for switching to this approach at 3 million. The 50/25/25 percent formula would give us:

  • 750k in bonds
  • 750k in RE
  • 1.5m in stocks

Once over 3 million it would start to change to a dollar allocation. For instance 3.350 million would then look like this:

  • 750k in bonds (22.4%)
  • 750k in RE (22.4%)
  • 1.85m in stocks (55%)

The point is not that one of these is “right” but rather this is another way to think about your asset allocations. Using it, the numbers can change to match your goals and personal preferences. However, I would suggest this is something for only those over 2 million in net worth to consider. Short of that, using the straight percentages is more helpful.

Let me know what you think in the comments.

Addendum 1:  Please note – I no longer hold VGSLX. Please see Stepping away from REITs for a discussion as to why.

Addendum 2: How EmJay went from zero to 2.6 million in 25 years.

More Case Studies

Posted in Case Studies | 59 Responses

Republic Wireless and my $19 per month phone plan

dark and stormy

Painting by Sergey Gusev

It was a dark and stormy night.*

She told me to wait. Maybe I should have listened.

But I was impatient and headed to South America. The idea of remaining in touch, of having access to my email, the internet and, wonder of wonder, free international calls was not to be denied.

“No!” I cried. “I must have it now! Now, I tell you! Now!”

“It will only break your heart,” she said, “as it has so many others. This is not the one for you.”

But I was blinded by love. No longer thinking rationally. The thought of travel to distant foreign lands without it suddenly became unthinkable. Unbearable. I would not be denied.

I bargained. Cajoled. Begged. Pleaded. Threatened. Ranted. Insisted. And, finally, (this one being true) just asked.

And the nice Republic Wireless (RW) PR lady sent me the Motorola Defy XT phone. I’ve hated it ever since.

 weep for me

Weep for Me

So that’s the bad news and, blessedly, the end of my little melodrama.

The good news is that I remain enamored with Republic Wireless, its service and the concept behind what they are doing here. Moreover they have a new phone coming shortly: The Moto X. While I can’t yet speak from experience (I can now and it is a HUGE improvement!**), by all accounts this one will be a major step forward and will put to rest many of the Defy XT’s shortcomings.

So, if you are a cut-to-the-chase sort, here’s the bottom line:

  • Republic is a fine company with which to deal and very much worth supporting.
  • Wait for the Moto X phone before you sign up. It shouldn’t be long. It is due in November.

The Phones.

Understand first, I am not a fan of technology. I am a fan of useful and reliable tools. When a technology reaches the point of being a useful and reliable tool, I’m on board. Unfortunately, many technology companies are infamous for using their customers in their beta-testing.

Depending on your perspective and inclinations, you will have read that last either as:

“Those rascals!”

Or

“Of course! That’s what makes tech so cool. I get to be part of the process!”

I’m a “those rascals” kind of guy and when they, and you “of course” types, get it sorted out, please let me know.

The problem with the Defy XT is that it is very much a phone for the “of course” types and since it is also tech that’s a couple of generations old, they have long since moved on. Time to just bury the thing. Thankfully, that’s what Republic is on the verge of doing.

In the beginning, I started a log to keep track of its many shortcomings. But with its pending demise, wading thru all those points in this post seems, well, rather pointless.

What is interesting, at least to me, is why Republic chose to go with such a flawed phone to begin with. The answer to that, apparently, is that Republic has the potential to break the expensive strangle hold other cell phone service providers have on us. That, it seems, has made the many cell phone manufacturers reluctant to supply Republic with their products. The revenue at this point would be peanuts and the risk of offending their bigger customers not worth taking.

Understandable. Cowardly, but understandable. Maybe shortsighted, too. Republic looks to have a very bright future, especially if the Moto X meets expectations.

Republic Wireless, the service.

When the nice PR lady first approached me about doing a review, her timing could not have been better. Our then cell phone service had just tried to hose us. Again.

My daughter had returned from her year studying in France. While she was there, we suspended her cell phone service. Part of that service was $10 a month for unlimited texting.

When she returned, we called and re-instated her service. With the first bill came a $400+ charge for texting. Oh, you wanted the unlimited monthly texting for $10 again? After an irate call or two they cut the bill to $100. Better, but being hosed is being hosed.

That, in a microcosm, is my (and I dare say your) typical experience with cell phone, and for that matter cable, companies.  They are forever looking to pad the bill and boost your monthly costs. Hoping you won’t notice and/or will let it slide. In dealing with them you’d best be always on your guard. And who needs or wants that? Especially with an alternative on the horizon.

So my first, last and only real question for the nice RW PR lady was this:

“Is there anything, anywhere I can do with this phone that will ever cost me more than $19 a month?”

“Nope,” she said.

“Just to be absolutely clear. Nothing at all? Intentionally? Unintentionally?”

“Nope.”

Impressively, this has proven to be true. I’ve used it here, there and everywhere, including unlimited calls, texts and data to and from South America and it is $19 each month.

Here’s my understanding of how it works:

Whenever you are in range of a wi-fi connection you connect and, just like your laptop, the phone uses the internet to download data. And also text messages and your phone calls.

If you don’t have a wi-fi connection, it defaults to the Sprint network and uses regular cell service. The idea is that most of the time, you’ll be using the internet and that is essentially free. The cellular service usage is typically small enough that the prices can be as low as they are.

Of course, the cellular service is only as extensive and as good as Sprint. Beyond their range, the phone only works in wi-fi mode. So, in South America for instance, my phone worked only when I had a wi-fi connection, just like a laptop or tablet.

cafe san sebas

Cafe San Sebas, Cuenca, Ecuador

My RW phone knows this place.

I quickly got in the habit of asking for wi-fi passwords where ever I went. The phone then remembers all of these and I have to say I found it pretty cool to return to my favorite cafes in Ecuador and have my phone automatically connect, just like coming home.

But for me the biggest plus is just dealing with a cell phone company that is not plotting to screw me. This is so refreshing it makes up for the shortcomings of even the Defy XT. Add to that the cost, which is a fraction of what we’d been paying, and you know why I plan to stay with RW. It kind of reminds me of dealing with Vanguard. And if you’ve read much of this blog, you know just how high that praise is.

This is not the service for you if….

….you value having the state-of-the-art newest and best phone from the company of your choice. For now, at least, RW = Motorola.

….are dependent on your phone for your business. In all candor, since I haven’t tested the new Moto X, I can’t yet recommend RW if your phone is also a critical tool.

However, this is the service for you if, like me, you value…

….low-cost. $19.95 per month for unlimited calling, texting and data – with no hidden traps – is tough to beat.

….supporting a company that is trying to improve service and choice in an industry that sorely needs it.

….supporting a company that, like Vanguard, truly seems to see value and success in putting the needs of their customers first.

….fast, friendly and competent tech help. Republic doesn’t offer a help-line number to call but they do offer several other options ranging  from a community forum right on down to snail mail (!). Personally, email works best for me and they’ve responded much, much quicker than the 48 hour window they promise.

moto s

Moto X

With the new Moto X phone they are now offering four different plans. Here they are, as described by RW and cribbed directly from their website:

$5 Wi-Fi only plan
This is the most powerful tool in your arsenal of options. Why? You can drop your smartphone bill —at will— to $5. If you’re interested in getting serious about cutting costs, you can use this tool to best leverage the Wi-Fi in your life to reduce your phone bill. It’s also the ultimate plan for home base stickers and kids who don’t need a cellular plan. It’s fully unlimited data, talk and text —on Wi-Fi only.

 $10 Wi-Fi + Cell Talk & Text
One of our members, 10thdoctor said :  “I use WiFi for everything, except when I’m traveling and for voice at my school.” Yep, this is the perfect plan for that. Our members are around Wi-Fi about 90% of the time. During that 10% of the time where you’re away from Wi-Fi, this plan gives you cellular backup for communicating when you need to. This plan both cuts costs and accommodates what’s quickly becoming the norm: a day filled with Wi-Fi.

$25 Wi-Fi + Cell (3G) Talk, Text & Data
Lots of people are on 3G plans today and are paying upwards of $100 a month on their smartphone bills. That’s nuts. This plan is here for you during the times when you need the backup of cell data. For folks who want to surf Facebook and check email in the car (as a passenger!) or who travel regularly for work, this option lets them enjoy all the benefits of Wi-Fi with the luxury of 3G cellular data. You may find you only want this cellular back up part of the month —no problem! Switching during the month to the $5 or $10 plan is easy, and is a great way to keep more money in your wallet.

 $40 Wi-Fi + Cell (4G) Talk, Text & Data
We heard you tell us that you wanted a super fast option, so we added this arrow to your quiver. This plan is here for you when you’ve got a road warrior kind of month, and you’ve got a serious need for speed. Have to get work done on a long train ride? And need to work fast? This is your guy. Just like the other plans, it’s just a few clicks away.

Will I be able to switch between plans?
Yes! When you purchase a new Moto X phone, you’ll be able to choose whatever plan you like—and you can also switch plans up to twice per month as your needs change. For example, if you know you’ll be taking a vacation and might require more cell data one week, you can switch to a cell data plan right from your phone and then switch back to a Wi-Fi “friendlier” plan once you return home.

That ability to switch as your needs dictate seems pretty sweet to me.

In short, despite the rough go with the Defy XT I’ll be sticking with Republic. Truth is, for all the issues, it was very cool to be able to call the USA from South America and still not push my monthly cost past that $19.95. Of course, that only worked when I had wi-fi available. But still, very cool.

Even more cool is the monthly savings and the sense that I’m now dealing with a company not looking to pick my pocket at every opportunity.

Assuming they stay true to this path, Republic’s future looks bright to me. I expect they will continue to expand and improve their service and the hardware.

I might even give the new Moto X a whirl.**

If you’d like to give Republic a try yourself, just click on the ad below. By way of full disclosure if you sign up, this blog will earn a commission.

Note:

*This phrase, in writer’s circles, is widely regarded as the most cliched, hackneyed and simply worst possible opening line in all of fiction. So of course I’ve always longed to use it. Now I have. I promise not to again.

Updates: 

November 14, 2013. The new Moto X phone has now been released. With it I can now give RW my unfettered recommendation. So if you want to give them a try, the time has come.

**June, 2014. Both my daughter and I just upgraded to the X and already the X is showing itself to be a major improvement. We were able to trade in our XTs for $100 credits. Good riddance!

My wife chose the G and she too is now free of Verizon.

Posted in Life, Stuff I recommend | 69 Responses

Case Study #3: Let’s get Tom to Latin America!

Latin_America_(orthographic_projection)

Image courtesy of Wikipedia

I wasn’t planning two Case Studies this close together. Really. But then Tom dropped this note in my lap (actually on Ask jlcollinsnh) and it proved irresistible on several fronts:

–It provides a chance to make a key point about F-You Money:

Unlike the amount needed for full financial independence (FI) and retiring, all that is needed is enough to embolden you to explore new and interesting options.

–It involves long-term international travel.

–It provides a great illustration of how to execute my 10-year plan without being stuck as an office drone.

–It provides a chance to illustrate how your F-You Money can grow to make you FI even while you’re off having adventures.

Let’s take a look at Tom’s situation, plans and questions:

Dear jlcollinsnh:

Help a Hoarder Go Back to School!

Hi! I’m a huge fan of your site. It’s nice to see your investing optimism amid all the doom and gloom of the mass media. Anyway, I’d love your advice on my current situation.

I’m currently working in a high paying job. It’s as life sucking as can be but the pay is amazing. At the end of this year, my contract will end and I’ll have amassed $250k in a checking account. Foolish, I know. It was my dumb “let’s try to time the market phase,” but I’ve grown out of it. You’ve shown me the light!

After this job ends, I plan to study in Latin America (I’m from the US) for five years. During these five years, I’ll have no income and expect to spend $16k a year, which is a firm, inflexible requirement. Once I graduate, I plan to permanently relocate and work in Latin America and start savings again, albeit at a much more modest rate than now. I’d then eventually like to retire early – perhaps around the age of 40.

Here are some stats:
Age: 28

Liabilities: $0.

Assets Upon Getting Laid Off and Going to School: $250k in checking, $17.5k in a Vanguard small cap 401k

Cost of School (2014-2018): $16k/year x 5 years = $80k

Savings Once Back in the Workforce (2019-2024?): $6k/year in savings (low salary but worthwhile profession)

Retirement Goal: (2025/age 40-ish): $450k in investments (18k/year withdrawal rate)

As I’m now an enlightened reader, I’m ready and excited to invest and have my money work for me. How would you suggest investing?

Note: I can only invest in taxable accounts, since I’ve already maxed out my Vanguard small cap 401k for the year and I am not interested in a Roth IRA as I plan to be in a low tax bracket during early retirement.

My current investment ideas include:

1. Keep the 80k needed for school low risk and highly liquid (high-interest checking and CDs?) and invest the remaining funds (170k) in the VTSAX, which I wouldn’t touch for at least 10 years. I’ll stay strong!

Pro: I’m guaranteed to not have to touch my VTSAX fund since I’ll have cold, hard cash to pay for school.

Con: I stupidly have too much cash sitting around.

2.. Take the entire 250k and invest in one of Vanguard’s conservative balanced funds, such as the Target Retirement Income Fund, or Lifegrowth Funds, or slightly more aggressive VBIAX and make monthly withdrawals as I go through school.

Pro: An excessive amount of cash isn’t sitting around doing nothing

Con: I risk having to make my aggressive 6.4% withdrawal rate during a possible down market during my time in school.

What do you think? I’m dealing with two different time horizon heres, Short term 1-5 years for school and medium term 10-15 years for early retirement.

Keep up the great work on the blog!!

Best,

Tom

croc feeding

Tom’s not been foolish. This guy, however….

Courtesy of http://www.break.com

Welcome Tom…

…and thanks for the very interesting scenario! Let’s get started with some general observations:

Don’t think of having held cash as having been foolish. Think of it as having been patient in figuring out what you needed to know about investing before making your move.

Looking at the two options you lay out, I’d say you’ve used your investment research time well.

Too often people rush into buying individual stocks or chasing “star” fund managers without understanding the landscape and how vanishingly difficult those paths are. Now that’s foolish.

Nothing at all wrong with holding your cash until you are sure about what you plan to do. This is for the long-term, after all. Time spent getting it right is time well spent. This includes time spent being sure you are mentally tough enough for the wild ride. Sounds like you are.

Speaking of being mentally tough, congratulations on being tough enough to:

  • stick out your high-paying sucky job long enough to set the stage for your adventure.
  • avoid the lifestyle inflation that could have trapped you in that job.
  • avoid taking on debt that would have made those chains even stouter.

All these are key parts of my ten-year plan linked to above. At age 28 you’ve managed to position yourself beautifully.

So let’s turn our attention to your two investment ideas and play with this cool Compound Interest Calculator I cribbed from Johnny Moneyseed’s recent post From employment to retirement in 7 years.

Scenario #1.

Actually, including the 17.5k you have in your 401k you are heading to Latin America with 267.5k.

If we pull the 80k you’ll need for the next five years into cash that leaves 187.5k to invest.

The 17.5 in the 401k Vanguard Small Cap Index fund is just fine left there for now. We’ll come back to it later. The rest — 170k — we’ll drop into VTSAX.

Now it gets fun, and a bit tricky.

Over time, the market returns somewhere between 8-12%. But with a five year time horizon, your actual results could range much higher. Or lower. I’m not overly concerned about this as your plan is to continue to keep this money invested and growing. So for the sake of this conversation, let’s run the numbers three ways. You’d end with:

  • $239,303 at a somewhat pessimistic 5%, but still offsetting 51.5k of the 80k you will have spent. Not bad.
  • $275,499 at a fairly modest historical return of 8%, more than replacing the 80k you will have spent. The beauty of money working for you illustrated!
  • $330,439 at an aggressive historical return of 12%, making you wealthier than when you started. Woo Hoo!

Now, what happens when you have been back working and adding that annual 6k from 2019 to 2024? Dropping each of the ending numbers from above in to our calculator, by 2024 you’d have:

  • $340,229 @ the 5% projection
  • $386,426 @ the 8% projection
  • $456,545 @ the 12% projection

As you can see, the bad news is that only one of these projections gets you to your 450k goal. The good news is you are now looking at a 10 year time horizon and the further out you go the more likely you are to get to the higher return levels.

So, even pulling the entire 80k you’ll be spending into cash up front gets you some pretty impressive potential results.

Scenario #2.

Keeping all the money fully invested, pulling it only as needed.

Since you are starting with 267.5k and you’ll be withdrawing 16k per year, you have a 6% withdrawal rate. If you haven’t already, now I’m going to send you over to give my post on withdrawal rates a read.

What you’ll see is that, while starting to push the envelope, 6% is not completely unreasonable. Especially given a bit of luck, the short time you’ll be doing it and the fact that, unlike somebody say 65 or so, you’ll have the ability to work your way thru it if the market turns against you.

Taking a look at the Trinity Study Update I referenced in that post, you’ll see what makes these academic withdrawal studies tricky is when they account for inflation over 30 years. Tough bar.

Comparing charts 3 & 4 you can see this clearly. Since it also designed to examine extended periods of 15 years or more, you need to be careful extrapolating to your 5-10 time frame. As we’ve discussed, the shorter the time frame the more likely your returns are to be outside the norm. For better or worse.

Understanding that, it is still instructive to look at chart #3 and the 15 year results @ 6%. Notice that 100% stocks gives the best results and that those results diminish the more bonds you add. Of course, 100% stocks will also magnify the “outside the norm” dynamic described in the paragraph above.

So now, hopefully, you can see I’ve set up a framework for your decision.

If you go with your scenario #1, you’ll get a good result but one likely to leave you a bit more work to do beyond 2024 before hitting your 450k goal.

Go with your scenario #2 and you’ll keep more money working (and at risk) and greatly improve your chances of being at 450k or more by 2024, but with a greater risk of a larger gap should the market move against you for an extended period. Go with a 100% stock portfolio version and you’ll magnify this effect.

So you’ll also need to decide between the idea of the balanced funds you mentioned or 100% stocks in VTSAX. It really depends on your temperament and goals. Personally, I’d be willing to risk having to work a bit longer against the potential of having more when I wrap it up in 2024. But that’s me.

girls-whispering

Psst. He might go for an option #2 version.

Not surprisingly, by extension, I’d go with one of the #2 versions. I’d set it up with Vanguard to transfer $1333 each month to my checking account and I’d never even glance at the funds while I was kicking it in Latin America.

As for a Roth, even though you plan to be in a low tax bracket, don’t be too quick to dismiss funding one. Things could change and you can always withdraw all your contributions tax and penalty free. Only the money it earns need be left in place, growing forever tax-free. It may never benefit you to the max, but it will benefit you. And there is no reason not to do it.

Ok, now back to that 401k. As soon as you are in your first year of no income, I’d roll this into a Vanguard Roth IRA. I’d also move it to VTSAX at this point, although if you are especially fond of the Small Cap Index fund that’s fine too.

While technically a taxable event, with no other income, at this amount the rollover should be tax-free. Once there it will grow tax-free forever.

Since for those first five years you won’t have income you won’t be able to add to it. But in 2019 when you start earning again, fund the Roth fully each year.*(See addendum #1) In fact, this is where most (up to the max allowed by law) of your planned savings in those years should go. Especially since it sounds like your income will be low enough not to need the immediate tax deduction.

There you have it. You are in a great position to pursue your new adventures while your money does the heavy lifting for you going forward!

What will you be studying and where exactly?

Travel safe and keep us posted!

 

*Addendum #1:

In the comments below reader Andres schooled me on the Foreign Income Exclusion for US expats and its effect on Roth IRA contributions. Here is our conversation…

Andrés:

One small wrinkle I’ve learned from living abroad: unless Tom makes more than the Foreign Earned Income Exclusion (which will be $97,600 for 2013 and is indexed to increase with inflation) he won’t be able to contribute to his Roth IRA if he is living and working full-time outside of the United States. However, he will be able to contribute to his taxable brokerage accounts as normal.

My reply:

Thanks Andrés…

Great input and something I didn’t know.

It got me doing a bit of research and I’d like to expand a bit on your comment.

The IRS says you can contribute to a Roth IRA if, in 2013 you

1. received taxable compensation during the year, and
2. your modified Adjusted Gross Income is less than certain levels which are detailed here:
http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2013

Since the first $97,600 of foreign income is excluded, unless you make more than this you wouldn’t meet the income qualification.

However, in determining your income limit, this excludable income is added back in.

For a single taxpayer like Tom the income limit for a Roth IRA starts at 112k and phases out thru 127k. That is between 112k and 127k you can fund part of a Roth.

So, if Tom makes $97,600 or less: No Roth. Since the income is excluded, he doesn’t meet the earned income test.

If Tom makes over 127k: No Roth. He is over the income limit.

If Tom makes 100k, he could contribute $2400 to his Roth. That is his total adjusted gross income of 100k – the 97.6k exclusion = 2.4k

If Tom were to make between 103.1k (97.6k + 5.5k) and 112k he’ll be able to fully fund his Roth at the allowed $5500. Once over 112k the amount allowed gets steadily reduced until it is gone completely over 127k.

Whew!

And this is why I hate writing about tax stuff! :)

Addendum 2:

Also from the comments below is this great strategy presented by Jay Jay. Tom should definitely do this.

Thanks Jay Jay!

Jay Jay:

I’ve been reading your blog for quite some time (love it, and thanks for doing it!), but this is the first time I’ve felt I might possibly add some insight.

Since Tom’s income will be so low, his dividends and capital gains should be tax-free (assuming his ex-patriot status doesn’t impact that) up to $32k or more, depending on deductions and exemptions.

I know you usually recommend a “set it and forget it” approach to index fund investing, but it might make sense in Tom’s case to consider occasionally selling off his fund if it has experienced some gains, and then immediately buying back into it. He would of course need to calculate what amount he could sell which would still keep him in the 0% cap gain tax bracket. If he remains in a 0% tax bracket, all he’s lost is his transaction costs.

This is sort of the opposite of a wash sale. Instead of locking in a loss, you are locking in a tax-free capital gain. It also re-establishes the cost basis, so if he ends up in a higher bracket in the future, his capital gains will be less than if he hadn’t made the sale/repurchase. As far as I am aware, there is no 30 day limit for sales/repurchases that involve a gain.

My additional considerations:

Because Tom will be using Vanguard funds he need not even worry about transaction costs, which Jay Jay rightly points out could be a consideration in other scenarios.

However, when using Vanguard funds there is this glitch:

“If you sell or exchange shares of a Vanguard fund, you will not be permitted to buy or exchange back into the same fund, in the same account, within 60 calendar days.”

The easy way around this is to exchange from VTSAX to VFIAX (S&P 500 index fund) and back to VTSAX after 60 days. While VTSAX slightly out performs VFIAX over time, for short periods either could win making this an non-issue. In fact, I’d be comfortable enough with VFIAX to say just leave the funds there until you are ready to harvest the profits again.


 More Case Studies

Posted in Case Studies, Travels | 29 Responses

The Stock Series gets its own page

nice post

Courtesy of: Brainless Tales Greeting Cards

A couple of days ago a reader named Kevin sent me a very nice post over on Ask jlcollinsnh. It is dated October 2, 2013 if you’d like to find it and read our exchange.

In it he said that he has found the blog interesting and useful, especially the Stock Series. Useful enough that he wanted to share those posts with his friends and family. Problem was he found it cumbersome to do so.

I replied thanking him and pointed out:

If you look at the right hand column you see every post here organized by category. This this the link to the stock series:http://jlcollinsnh.com/category/stock-investing-series/

MMM also created a post with links as well:

http://www.mrmoneymustache.com/2013/03/07/how-about-that-stock-market/

As did Shilpan over on Street Smart Finance:

http://www.streetsmartfinance.org/2013/06/28/how-to-invest-money-in-any-economy/

Kevin replied saying, basically,

“Yeah, yeah. Got that. Still doesn’t cut it. Stop procrastinating. Get off your ass and create a new tab at the top for these things.”

(Actually, he was very kind, polite and profanity-free in his reply. I’m just reading between the lines as to what I would have meant.)

Well, persistence pays and Kevin’s prompted me to turn to my technical advisor The Mad Fientist. I put the idea to him and he replied saying, basically:

“Yeah, dummy. That’s what I’ve spent the last year or so telling you to do.”

But again, in much nicer words. And, of course, on reflection this is the same message Mr. MM and Shilpan were sending me with their very generous posts.

homer_simpson_d__oh__by_seekerarmada-d5jl5wh

Well, never let it be said that I don’t recognize a good idea when it’s banged over my head repeatedly and by multiple people for extended periods of time.

So, with thanks to all (and especially Kevin who provided the proverbial last straw) I give you the newly and better organized:

Stock Investing Series

You’ll notice this has also given me a chance to include several related posts not formally included in the Series. If you’d like to see others added, please let me know. I don’t always listen right away. But sometimes I get there.

Posted in Stock Investing Series | 24 Responses

Case Study #2: Joe — off to a fast start!

fast-start

Over in the Ask jlcollinsnh page, reader Joe posted a very interesting profile along with a series of questions.  Since I think his situation and our conversation about it might have broad interest, it has become our first case study in a long time (here’s #1) and this post.

First is his note, which I have edited a bit, but only to include some facts he later provided:

Jim -

I wanted to layout my personal situation for myself and my girlfriend and get some feedback from you re: any things you think we’re missing out on or areas of opportunity.

(Joe is 27 and his girlfriend is 24. The income and expenses are his alone. She is a full-time student.)

Monthly Income
* Salaried at $12,500/mo with quarterly bonuses based on profit. Given past profit numbers this should equate to about $3,300-4,200/mo. Total comp: $15,800-16,700/mo.

 I get 100% covered health insurance, dental, etc. I have disability insurance through work.

Monthly Expenses
* Housing (own) = $1,315/mo (House mortgage + property taxes + pmi)
* Bills & Utilities = $423/mo (Gas, Water, Electric, Internet, Cable TV, Cell Phone for myself and GF)
* Transport = $287/mo (Car Insurance, Gas, Maintenance, Parking, EZPass, Transit Pass, Bike Maintenance)
* Food & Dining = $321/mo (Groceries, Restaurants, Bars)
* Shopping = $330/mo (House goods, clothes, electronics, gifts)
* Pet care = $59/mo (Dog food, annual vet visit, toys)

Annual Expenses
* Travel = ~$3.2k/year, $260/mo (g/f family is INT’L so we need to travel at least once per year)

Monthly Investment Contributions
* Roth 401k = $728/mo
* 401k = $728/mo
^^ Note: Company matches to the tune of about $200/mo
* Principal Payment = $300/mo (Pay an extra $300 towards house)
* Vanguard taxable = $4k/mo (55% VTSAX, 15% VGTSX, 15% VGSIX, 15% VBMFX)

TOTAL INCOME: $16,250/mo
TOTAL EXPENSES: $2,995/mo
TOTAL INVESTMENTS: $5,756/mo

In terms of what I’ve gotten so far:

Assets
* House, Zillow = $255k
* CASH = $53k
* Car, KBB = $13k
* Roth 401k = ~$18k (Principal Target 2045 Retirement Fund)
* 401k = ~$18k (Principal Target 2045 Retirement Fund)
* Old 401k = ~$28k (Assortment of funds available in Fidelity)
* Vanguard Roth IRA = ~$21k (Target 2045 Retirement Fund VTIVX)
* Vanguard Taxable = ~$20k (55% VTSAX, 15% VGTSX, 15% VGSIX, 15% VBMFX)

Liabilities
* House Mortgage = $173k

QUESTIONS

  1. Anything good to do with some of that cash to keep it mostly liquid / safe as an emergency fund + life fund (marriage, new car, etc)? It’s just sitting in Capital One 360 + Bank of America.
  2. I just upped my investments, my plan is to up the contribution amount until I am breaking even every month and not growing my savings. Based on what my predicted income, taxes, spending, and current investment contributions are, I think that means I will likely push my monthly investments up another $3k/mo.
  3. I can rent out my house for ~$1,700 and move closer to my work for a monthly rent of ~$1,800. I would save about an hour per day by being closer to work, and given the the fact that utilities would be cheaper and I would make money on top of mortgage, it seems like a good idea. Thoughts?
  4. Should I consider saving some money and buying another house for myself as either an investment property or a house to live in (thus converting my current into an investment property)? Around me it is common to buy a house for between $250-350k that is pretty nice and it can rent out for $1500-2500.
  5. Are the target retirement funds decent?
  6. Am I missing out on any big opportunities in my portfolio?
  7. Does it seem like I’m on a good track?

Joe

My Reply

Welcome Joe and thanks for your detailed profile. Let’s start by answering your last question (#7) first:

Beautiful Track 5

It seems you are on an beautiful track!

Well done so far.

You have just about 200k in income and you are living on under 36k per year. That’s an annual savings rate of 82%. That’s brilliant. About the only thing that appears to be missing is accounting for the repairs and maintaince your house is sure to require over time. But think hard and be sure you’re not missing anything else in your expense profile.

If those expense numbers are accurate, and for anybody living on 18% of their income, I’d say spend it on whatever you damn well please.

OK, let’s look at your other six questions, in order:

1.  53k in cash, for somebody with your income and spending level, is needlessly high. It is just shy of 1.5 years of your current living expenses.

If wedding costs and/or a new car are in your near term plans, figure those costs and hold that aside as cash. Otherwise, half your annual spending is more than enough: 18k. And unless your job is insecure, I wouldn’t even hold that much. But with your assets, if you want to, it is a small enough number.

Make that money work harder: Move the excess to VTSAX (Vanguard Total Stock Market Index Fund) in your taxable account.

2. You should push your investment levels far higher. Subtracting your expenses ($2995) from your income ($16,250) you have a monthly surplus of $13,255. Yet you are only investing $5756, leaving $7499 unaccounted for. Since you don’t mention if your income is pre or post tax, some of that might be going to the tax man. But you still have much more to deploy.

3. Your idea of moving certainly makes sense from a cost and commute time savings point of view. However, with your income and savings rate, I’d make the call based more on which option provides you the most appealing lifestyle.

4. Having a rental house can be a very attractive investment. But it can also be a money pit. Do some very serious homework first, rather than just buying another house and converting your current home into a rental.

Remember, too, this is also a part time job. If this appeals to you and you see it as a desirable way to spend your free time, go for it. If not, you have no real need here.

A REIT like VGSLX  (Vanguard REIT Index Fund) gives you broad-based real estate exposure while you read a good book sipping cognac by a roaring fire.

If you haven’t already, start by reading this: Why Your House is a Terrible Investment.

5. I am not familiar with Principal Target 2045 Retirement Fund, but taking a quick look it seems OK. The .63% ER (expense ratio) is a little pricey. (Your Vanguard Roth in VTIVX, the Vanguard equivalent, has an ER of .18% for comparison.) My guess is you are in it because that’s what’s offered in your 401k. That’s fine, but when you leave that employer you’ll want to roll it into a Vanguard IRA (unless you are using the Backdoor Roth strategy described below). There will be no reason not to own the better, lower cost VTIVX in your IRA/Roth then.

Here’s my take on TRFs overall.

6. Not big opportunities, but your portfolio could use some fine tuning. Let’s look at that next…

rock pushing

We’ll just move a few little things around…

Open a non-deductable IRA…

and immediately convert it to a Roth IRA. This is a very cool technique called a Backdoor Roth IRA.  High income earners utilize this to get access to a Roth.

There are some complications to this (as described in the link), the  main one being that such a conversion will also effect all IRAs held other than Roths. But you don’t have any others. Your personal situation is such that you’ll avoid this common complication altogether.

Here’s what you do:

Read that linked article carefully. Then….

Open an IRA with Vanguard (you don’t have to specify deductible or non-deductable) and put the max contribution ($5000) into VMMXX: Vanguard Prime Money Market Fund. You want the money market fund so you have as little variation in value as possible in the short time you hold it as value variations add complexity.

Immediately instruct Vanguard to transfer it into a Roth IRA. You can use your existing Roth. You now have a perfectly legal Roth contribution in spite of your high income. And you can do this every year. Just be sure you don’t open any other IRAs or roll any 401k money into an IRA.

You won’t get any immediate tax deduction, but earnings will grow tax sheltered; important in your tax bracket.

BTW, for those readers who have lower incomes that allow for traditional deductable IRAs, my pal the Mad Fientist has worked out some very clever strategies:

http://www.madfientist.com/retire-even-earlier/ Check out the section on Roth IRA Conversion Ladder

http://www.madfientist.com/traditional_ira_vs_roth_ira/

Old 401k 

Ordinarily, I’d suggest you promptly roll this out of Fidelity (where the funds are likely to have high ERs) and into an IRA at Vanguard holding VTSAX. But that would vastly complicate the Backdoor Roth strategy above. So do this only if you decide against the Backdoor.

If you do decide to use that strategy, keep the old 401k but with an eye towards consolidating the multiple funds you have into Fidelity’s Total Stock Market Index fund, if available. Responding to the competition from Vanguard they have made these very low cost and it will serve you well.

If they don’t offer the Total Market Index fund, look for the S&P 500 Index Fund. That will serve nicely. So would a Target Retirement Fund if you prefer one of those.

Vanguard Roth IRA in VTIVX

I guess is this is an older Roth built when your income was low enough to allow Roth contributions? If not, I see a problem. As a single guy, your income disqualifies you from contributing to a Roth.  (Other than the Backdoor discussed above.) The phase out limits range from 112k to 127k. Past 127k you can no longer contribute at all. If you built up this Roth when your income was within the limits, no worries. If not, you’ll have to back out of it.

As for VTIVX, this is a fine fund. But Roth money is very long term and you already hold a very similar fund in your 401k. I’d use VTSAX instead. It will be a more volatile ride, but if you leave it alone after 40-50 years it will very likely have delivered a much stronger return.

Vanguard Taxable

You have 20k spread across four funds and you are adding 4k per month. That’s great, but you don’t need so many funds. I’d simplify and focus all this into VTSAX for the reasons I outline here, and this is why I don’t feel the need for international funds.

Mortgage

While I don’t have a great problem with you paying an extra $300 per month, I also don’t see the need. If your interest rate is 4.5-5% or less, better to invest this money in VTSAX. If your interest rate is higher, look into refinancing.  With your income and lack of debt, they should fall all over themselves offering you their best terms and rates. I’d go for a 15 year fixed. It will be a higher payment than a 30 year but you’ll be done with it sooner.

I’d also borrow a full 80% on your 255k value = 204k. This is higher than your current 173k balance and not the advice I’d give to most. But this debt is so small compared to your income and your tax bracket is so high, you can easily afford it and will benefit from the tax deduction. Put the excess you receive right into your VTSAX fund.

Oh, and if you keep this mortgage you now have more than enough equity to have them dump the PMI. That’s wasted money for you and I’d get it gone ASAP.

OK, now…

lets_review

First, keep on with your terrific savings rate and increase your investing pace. Soon enough you’ll find your investments are producing the 36k you are spending. When that happens, live on that and invest your full income. Your investments will then really explode, as will the income they can provide. At that point, feel free to expand your lifestyle to that increasing level. For more on how much spending your investments can support, here’s my piece on the 4% rule.

Second, notice we are simplifiying and streamlining your investments. At this point in your life you are in the very active wealth building phase and VTSAX is the best tool for that. Both in your taxable and tax advantaged accounts. Because it’s what is offered in your 401k, you’ll also be holding the Principal Target 2045 Retirement Fund. That’s fine and you can roll it to Vanguard when you move on from this job, depending on your use of the Backdoor Roth.

Third, we are introducing that last as way to access the benefits of a Roth.

Fourth, your house is very modest against your income and that will serve you very well. Unless you can advantageously refinance, don’t worry about the mortgage. But dump the PMI.

You are off to a fine start and with your income, spending level and savings rate should easily hit finacial independance in short order.

Good luck and keep us posted on your progress!

Addendum:

For more on the idea of buying another more suitable house and turning your existing home into a rental:  How a smaller house saves us $16,500 a year.

More Case Studies

Posted in Case Studies | 67 Responses

Chautauqua 2013: A Week of Dreams

Chau - crater_lake-300x170

Lake Cuicocha:  Where we had lunch and a boat ride in the crater of a volcano.

First, thank you for you patience. I always feel a bit bad closing down the blog and leaving you with only past posts while I wander about during my summer travels. Not bad enough to stay home and write, or to lug along a laptop, of course. But bad.

Still after roaming around Ecuador for the better part of the summer, this past Sunday I returned, exhausted and having to relearn a few things about living here in the USA. Such as flushing the toilet paper down the toilet. See, in Ecuador nothing gets flushed that doesn’t, ahem, come directly from you. Used toilet paper is placed in the basket conveniently provided. Yep. Even the paper soiled that way.

Seems the septic systems can’t handle it. This despite the fact, as Mr. Money Mustache explained to me, septic systems “like” toilet paper.  It never occurred to me that they’d like anything but, when you consider the rest of what the systems deal with, a little TP is likely a step up.

But anyway, I’m back just in time for what is starting out as a drop-dead gorgeous fall season here in New England. As I told somebody recently, if I didn’t live in New Hampshire it would have to be on my annual travel schedule each year for these couple of months. Tomorrow my pal Barry, who has been storing my Triumph, is coming by to pick me up. Shortly after we’ll be in the wind, riding the back roads around these parts.

Ecuador, as always, was a magical trip. Seems I’ve been often enough now that upon my return the border agent felt the need to quiz me closely on just where I live. Jeez.

But the final week was the most magical of all. It was a week of dreams. It was the week of the Chautauqua.

mustachian_salute-300x225

Chautauquaians giving the newly created Mustachian Salute:

Finger mustache, arm gun displayed.

It was the premier event for Cheryl’s company, Above the Clouds Retreats and the realization of her dream to launch her company, sharing Ecuador and her Happiness and Passion path.

It was the realization of the dream of a local family who, after over a year of living in a chicken coop, are now about to move back in to their newly renovated house. Earthquake damage repaired with funds provided from the revenue this Chautauqua generated and channeled thru Cheryl’s Project One Corner.

Chau - the_family-300x198

The four of us with the Ecuadorian family and their refurbished home.

Listening to this Ecuadorian woman describe what being able to return to her home meant for her family had tears streaming down Cheryl’s cheeks as she translated. Mr. MM and I were sitting together on a low concrete wall. He leaned over and whispered something to the effect of “It is taking all my manly badassity to keep the tears at bay.” I was glad it wasn’t just me.

It was a dream realized for the kids at the orphanage we visited as they received the backpacks and other goodies attendees provided. Including the piñata that when finally burst showered them with goodies.

chau pinata

It was a boost to the realization of the dreams of every attendee. I know this based on my many personal conversations and by the fact that on every evalutation form we recieved, the answer to this question –

Would you recommend this Chautauqua to a friend?

– was “Yes.”

It was the realization of my dream to create a “Chautauqua” (one of my favorite old-timey words) where I could discuss the ideas on this blog personally with readers and in the company of presenters like Cheryl, Mr. Money Mustache and JD Roth, from each of whom I was eager to learn. They did not disappoint!

Cheryl is one of the most relentlessly happy and joyful people I’ve ever met, and not because her path has been an easy one. No one was listening more closely than I as she discussed her secrets.

From the moment Cheryl and I began discussing this Chautauqua, I knew we needed Mr. Money Mustache on board. If you read his blog you already know why. What you might not know is that he is every bit as formidable in person and an extraordinarily gifted speaker to boot. Fun to hang around with too.

Mr. MM also deserves the credit for whistling in JD Roth. JD’s presentation on “Fear, Flow and Freedom” was the one I was personally most anxious to hear. Remarkable stuff and at the end it even inspired me to do what ordinarily I would never have done: Ask the group directly for help.

See, for literally decades people have complemented my voice. While I did have the chance to do a bit of radio work, serendipity has never led to doing voice overs. I’ve always thought that would be fun and so I put it out to the group. As JD said, in effect I had just bought 26 lottery tickets.

Now, by extension and further using JD’s principles, I am buying many, many more by sharing this with you, my readers. If you want to hear what I sound like, you’ll find a link to my podcast with The Mad Fientist here. Another Chautauqua dream in the process of being fulfilled.

There is a certain process that occurs in pulling an event like this together. The concept is created. The speakers lined up. The destination chosen and secured. The P&L spread sheet created. The costs analyzed. The week planned and arranged. The endless details attended to. And finally the invitation to attend is offered. It is not unlike planning a grand party and then holding your breathe hoping the guests will actually come.

Chau - me pete jd

Fine tuning the Chautauqua at Cheryl’s farm house the day before the event.

We need not have worried. All 25 slots sold out in three weeks. Unfortunately, life intervened for a few people forcing them to cancel. Come arrival time at Quito International Airport we had 22 attendees plus the four presenters and Cheryl’s husband Rich, who handled the logistics and served as master of ceremonies. 27 people.

And what an amazingly diverse group it was. Not just in race and sexual orientation, although we enjoyed both. But in:

  • Age – ranging from geezers like me to folks in their twenties.
  • Occupations – including a corporate lawyer, doctor, banker, a couple of CFOs, a librarian, two US Marines, entrepreneurs, a fellow blogger and IT folks just to name a few. Some already FI, some on their way. Even a Wall Street money manager and a former stock analyst. Amazingly, given my views on Index Funds and Investment Advisors, both were still speaking to me after my presentation.
  • Wealth – ranging from multi-millionaires to people just breaking out of the grip of debt and on their way.
  • Geography – they came from all over the US and Canada, and one from Mexico.

You might think such a wide-ranging group would be a recipe for conflict. You would be wrong. As the Wall Street guy said to me towards the end, he and his friends amuse themselves at conferences with assessing the “AQ” of the various groups. That would be “asshole quotient.” His AQ score for this group: Zero. I’d have to agree.

chau - party time at Pete's

Mr. MM hosting one of many impromptu parties at his Hacienda Cusin casa.

In fact, it was absolutely stunning how well everybody got along. No matter how we mixed up the group (something we did very intentionally during the week) at meals and between events the conversations were universally robust, friendly, engaging, humorous and enlightening. These are all people who are fiercely independent and who are following their own unique paths.

On reflection, all this is not surprising. For all their diversity, getting to the Chautauqua required a couple of potent filters.

  1. Nobody signs up for a week in a distant country with a bunch of strangers without a pretty strong sense of adventure.
  2. All came to the Chautauqua thru one of our three blogs, and if you enjoy one the chances are good the others will resonate with you as well.

At a very fundamental and core level, we were all kindred spirits. In fact the comment I heard most often was how refreshing it was for attendees to be with other people who “get it.” If your goals involve FI, intentional living and personal freedom, in most circles you’re the odd one out. Talk about this stuff to most of your family, friends and co-workers and they’ll look at you like you have two heads.

But at the Chautauqua, almost by definition, these were core values everybody shared. The people there built, expanded and drew support for them with every encounter.

Associating with all these dynamic, smart, accomplished, positive and independent people was an endless joy for me. I learned far more than I taught. In this I can say with great confidence I was not alone.

So, to all who attended:  Thank you for making this event one of the best trips and best weeks of my life. Truly a dream realized. I salute you:

chau wine toast

To those reading, I only wish you, too, could have been there.

For other takes on this event:

Mister Money Mustache

JD Roth

Johnny Moneyseed

One life, many adventures

Carlos reports on the ERE forum

Unfortunately, we were unable to video tape the presentations as planned. But in their posts both JD and Mr. MM provide links to their slides for your reference. As for me, I’ll provide a recap of mine in a soon-to-come post.

A note on the photos in this post:

At the Chautauqua we had three expert photographers in Rich, Mr. MM and JD. Since this is one of the many skills I lack I’ve shamelessly cribbed those you see here from them. Cheryl also tells me she plans to put a bunch up on the Above the Clouds website. When she does, I’ll post the link. The embarrassing ones are sure to be included.

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Posted in Chautauqua, Travels | 63 Responses