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.
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 40s 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 reallocation 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.
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.
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
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)
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 reallocation 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 reallocation 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 paychecks 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.
Walking thru the questions
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 whatever 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 through 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 reallocation 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 reallocate.
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.
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.
Follow-up: January 10, 2016. In the comments below, EmJay checks in and tells us how things have gone since this case study over two years ago.
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 hyperinflation. 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.