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
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.
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…
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…
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!
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.
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.
