Using Your 401(k) and Roth IRA as Emergency Funds

savebuttonbankWe’ve all heard that you should keep an emergency fund in case of unexpected expenses or unemployment. But does it have to be in cash? Personal finance author Jonathan Clements presents a mathematical argument for using your 401(k) as an emergency fund in his recent article The Terrible Twenties. Here’s how the math works.

Let’s say you are in the 15% federal income tax bracket and you put $2,000 in your employer’s 401(k) plan. Your out-of-pocket cost would be $1,700, thanks to the initial tax savings. At the same time, your employer matches your contributions at 50 cents on the dollar, with the matching contribution vested immediately. Result: Your $2,000 investment gets you a $1,000 match, bringing your account balance to $3,000.

If you are then laid off and forced to liquidate your retirement account to pay living expenses, you might lose 15% to federal income taxes, plus another 10% to the tax penalty for making a retirement account withdrawal before age 59½. That combined 25% hit would still leave you with $2,250, well above your $1,700 out-of-pocket cost.

To be fair, this isn’t nearly as radical as it seems. Most prioritized lists of “where I should put $XXX?” will put a 401(k) up to the company match as the #1 priority, even above a cash emergency fund.. A company match gives you a way to earn a 50% or 100% instant, risk-free return on your money. This is a rare opportunity that you shouldn’t pass up.

However, not mentioned is that after you exhaust any 401(k) match, you could also consider contributing to a Roth IRA and using that as your emergency fund. The primary reason for this is that Roth IRA contributions can be taken out at any time, without penalty. Unlike Traditional IRAs, withdrawals from Roth IRAs are subject to ordering rules (see Chapter 2 of IRS Pub 590-B), which state that you always withdraw your own contributions first.

In either case, since you can only contribute a certain amount to 401(k) and/or IRAs every year, it would be wise to take advantage of this tax-sheltered space as much as possible. Don’t make a withdrawal if you can avoid it, but if you have limited options, it can make sense to contribute first and hope you can keep the money invested for retirement.

Early Retirement Portfolio Income, 2016 Mid-Year Update

dividendmono225I like the idea of living off dividend and interest income. Who doesn’t? The problem is that you can’t just buy stocks with the absolute highest dividend yields and junk bonds with the highest interest rates without giving up something in return. There are many bad investments lurking out there for desperate retirees looking only at income. My goal is to generate portfolio income that will keep up with inflation.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (Taken 7/31/16) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
24% 1.83% 0.44%
US Small Value
WisdomTree SmallCap Dividend ETF (DES)
3% 2.98% 0.09%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
24% 2.71% 0.65%
Emerging Markets Small Value
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
3% 3.14% 0.09%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 3.21% 0.19%
Intermediate-Term High Quality Bonds
Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX)
20% 2.82% 0.56%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
20% 0.82% 0.16%
Totals 100% 2.18%

 

The total weighted 12-month yield was 2.18%. This means that if I had a $1,000,000 portfolio balance today, it would have generated $21,800 in interest and dividends over the last 12 months. (I will note that the muni bond interest in my portfolio is exempt from federal income taxes.) For comparison, the Vanguard LifeStrategy Moderate Growth Fund (VSMGX) is an all-in-one fund that is also 60% stocks and 40% bonds. That fund has a trailing 12-month yield of 2.04%, taken 7/31/2016.

Both of those yield numbers are significantly lower than the 4% withdrawal rate often quoted for 65-year-old retirees with 30-year spending horizons, and is even lower than the 3% withdrawal rate that I usually use as a rough benchmark. If I use 3%, my theoretical income would cover my current annual expenses. If I used the actual numbers above, I am still slightly short. I will admit that planning on spending only 2% is most likely too conservative. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years.

I still like this income yield calculation as very conservative lower bound that adjusts for stock market valuations (valuations go up probably means dividend yield go down) as well as interest rates (low interest rates now, probably low bond returns in future). As an aspiring early retiree with hopefully 40 or even 50 years ahead of me, I like having safe numbers given the volatility of stock returns and the associated sequence of returns risk.

Early Retirement Portfolio Asset Allocation, 2016 Mid-Year Update

portpie_blank200Here is a roughly mid-year 2016 update on my investment portfolio holdings. This includes tax-deferred accounts like 401ks, IRAs, and taxable brokerage holdings, but excludes things like our primary home and cash reserves (emergency fund). The purpose of this portfolio is to create enough income to cover household expenses.

Target Asset Allocation

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I try to pick asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I don’t have enough “faith” in their fundamentals to hold them through an extended period of underperformance (i.e. don’t buy what you don’t can’t stick with).

Our current target ratio is 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With a self-managed, simple portfolio of low-cost funds, we minimize management fees, commissions, and income taxes.

Actual Asset Allocation and Holdings

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Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard Intermediate-Term Tax-Exempt Fund (VWITX, VWIUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
U.S. Savings Bonds (Series I)

Commentary
Since my last quarterly update, I’ve done the “just keep swimming, just keep swimming” thing and continued dollar-cost-averaging into the same investment mix. Nothing seems like a great deal, but I remain optimistic. I have not made any sell transactions. I still hold WisdomTree SmallCap Dividend ETF (DES) and WisdomTree Emerging Markets SmallCap Dividend ETF (DGS), as I still like the idea of holding a bit extra of those asset classes even though the ETFs available are not all that great.

I’m still somewhat underweight in TIPS mostly due to limited tax-deferred space as I really don’t want to hold them in a taxable account. (I should note that shares of TIP and VIPSX are up roughly 7% YTD, but the forward real yield is now negative). My taxable bonds are split roughly evenly between the three Vanguard muni funds. The average duration across all of them is roughly 4.5 years.

A simple benchmark for my portfolio is 50% Vanguard LifeStrategy Growth Fund (VASGX) and 50% Vanguard LifeStrategy Moderate Growth Fund (VSMGX), one is 60/40 and one is 80/20 so it also works out to 70% stocks and 30% bonds. That benchmark would have a total return of -0.87% for 2015 and +6.61% YTD (as of 7/31/16).

I like tracking my dividend and interest income more than overall market movements. In a separate post, I will update the amount of income that I am deriving from this portfolio along with how that compares to my expenses.

The Power of Default Settings: 401(k) Auto-Enrollment

A new ProPublica article by Lena Groeger discusses the power of default settings in our life – from organ donations to computer font settings. Included was an interesting case study of a company who implemented automatic enrollment into the company 401(k) for new employees. Here’s the drastic difference in the 401(k) participation rate (vs. time at company) for the two groups, auto-enrolled (AE) and not:

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Keep in mind, in both cases the employees could have changed their participation status at any time. No change was ever required, only the default initial setting was changed.

The study cited also points out the auto-enrolled default settings could also make some employees save less than they would have otherwise. For example, if the initial deferred percentage is only set at a 2% savings rate however, many people will just stick to that number whereas if they picked on their own it would be higher. People may believe the default setting to be the “expert recommended” or “popular” choice.

The same thing applies for escalation of savings over time. If there is no auto-escalation feature that increases the savings rate as income increases, some people will stay at the initial default savings setting for years or decades.

Suggested Best Practices. By combining their findings, the following best practices are presented as an example.

  1. Auto enroll all current and future employees into the plan.
  2. Set the initial deferral percentage at no less than 6 percent.
  3. Employ an automatic increase of a 1 or 2 percent deferral rate, to a maximum of no less than 15 percent.

Most of have a lot of great goals (eat better, save more, waste less time), but it will always be hard to make the best decisions all the time. We should respect the power of default settings, and use the same concept to help keep us on the right path for the future. For example, at our company retirement plan, we have an auto-escalation feature but we must opt-in manually. If I invest the energy to turn that option on today, we’ll have a better default for future years, knowing we might get lazy in the future.

Lifetime Allocation Pie Chart: Learning, Earning, and Returning

You always see pie charts used to illustrate asset allocation for portfolios. Stocks, bonds, commodities, real estate, etc. How about a pie chart for deciding how to allocate your lifetime:

life_aa

This was one of the “life lessons” provided by entrepreneur Tristan Walker in his Bloomberg profile:

Spend the first third of your life learning, the second earning, and the third returning. I try to shorten earning so I can maximize returning.

Your time on earth is a finite resource. Let’s say you put your life expectancy at 84 years. That works out to:

  • From birth until 28 years old, you are Learning. You are building up your knowledge, skills, and experience. You are building human capital.
  • From 28 to 56 years old, you are Earning. You are converting your human capital to traditional capital – money!
  • From 56 onwards, you are Returning. Once you have enough, it is your turn to give back to your community.

Learning isn’t always done in school. For example, many people will tell you that in your early years, you should take on risks before you develop too many other responsibilities. Start a business, switch careers, or travel the world. Don’t worry about the money in your 20s; your basic food and shelter expenses can be barebones. Invest your time into yourself.

Along the same lines, you won’t stop learning completely at 28 years old, but your focus and priorities may change. As I get close to 40, I feel the growing pressure of providing security for my kids and the pressure of caring for aging parents. In practical terms, you’ll need to invest more of your time into making money. Well, I might change that to earning money and then saving a big chunk of it.

Then one day, hopefully sooner than later, you can move on to giving back in a way that aligns with your personal philosophies. Invest your time towards helping your family, friends, the local community, and the world.

This is a related concept to the Earn, Save, Grow, Preserve lifecyle.

Infographic: 401(k) Plan Participation Stats

As we pass the halfway mark of this year, it was time for my quarterly check-in on my 401(k) account. The best-case scenario for a 401(k) plan is:

  • Company match. A little extra help from your employer is always nice.
  • Good default settings. The set-up process should be easy and completely painless. Ideally, you should be automatically opted-in for a some level of savings into a a diversified, low-cost option.
  • Low-cost investment choices. The less you pay, the more you keep.
  • Low account fees. Ditto.

For more and more Americans, the 401(k) is their primary vehicle for retirement. Here’s a good visualization from Bloomberg about the year-by-year decline of pensions (defined-benefit) and the rise of 401/403b/similar (defined-benefit) plans.

401k_bw2

Here’s another infographic from Bloomberg comparing income level, the availability of a 401(k) or similar plan, and the actual participation rate in such a plans.

401k_bw

The higher the income, the more likely you have access to a 401(k) or similar plan. In the highest-paid quartile, 96% of people with the option do participate. Not too surprising. The most interesting takeaway was that even in the lowest income quartile, if you offer a 401(k) plan, the majority of people will participate! The sad part is that only 35% of the lowest income quartile are even given the option.

Improving all the factors I listed first above (company match, lower fees) is still a good thing and is often talked about. However, it would seem like the best thing would be to widen the availability of such an option to everyone. This was probably the thinking behind the creation of myRA, but behaviorally there are still too many obstacles to signing up for the program. It still requires work and opt-in with no immediate benefit. There’s a reason why there are always sign-up bonuses for bank accounts – filling out applications is tedious.

If every time I was harassed to switch to paperless statements with “just one click”, someone was instead harassed into setting up a retirement plan with auto-contributions with “just one click”, there would be a lot more savings.

Where Should You Focus Your Energy? Earn , Save, Grow, or Preserve

While I often talk about your savings rate as an important metric for reaching financial freedom, I also follow that up by talking about managing both parts of that formula: earning more and/or spending less. Focusing your energy on a specific task is often better that trying to do everything perfectly and getting frustrated when you can’t juggle all the balls at once.

Financial planning expert Michael Kitces has come up with a helpful framework called The Four Phases Of Saving And Investing For Retirement that is related and also takes into consideration your portfolio size. This graphic he created explains it well:

fourphases

Here are my own notes and paraphrasing (please read original post for his own words):

  • Earn. First, you need income. Focus on your human capital to help you earn more. Invest energy into your education, career skills, and network (surround yourself with good people). If it fits your personality, take a risk and start a business.
  • Save. Once you have significant income, be sure to save a big portion of it. Create systems and habits to help keep your spending modest. A 30% or 50% savings rate for above-average earners is not out of the question.
  • Grow. Once you have significant savings, spend some time developing a set of solid investment beliefs and a written plan. Devote time specifically to learning about investing and/or find and hire a trusted advisor. Your money should always be making more money.
  • Preserve. You should only need to get rich once. Do you have proper insurance in place? Create a long-term plan to preserve and ultimately live off the income from your investment portfolio and other assets.

You can pay attention to the other areas, but I like this lifecycle method of prioritizing your finite time and energy.

Morningstar Target Date Fund Comparisons: Vanguard, Fidelity, T. Rowe Price

tdfauto

Target Date Funds (TDFs) get their name because they adjust their portfolio holdings automatically over time based on a given target retirement date. The overall growth of TDF assets continues, especially within employer-based 401(k) and 403(b) retirement plans. Morningstar recently released its 2016 research study called 2016 Target-Date Fund Landscape:

After laying out a general overview of the target-date industry, this year’s report highlights analysts’ best practices in comparing and contrasting target-date series according to Morningstar’s ratings pillar framework, demonstrating the benefits of going beyond conventional evaluation practices.

I found the report full of interesting statistics and insights, but at 84 pages it is also rather long. Here are what I consider the highlights.

The Big 3 providers are still Vanguard, Fidelity, and T. Rowe Price. As you can see below, they combine for 70% of all TDF assets. This number is actually slightly lower than three years ago, however. Vanguard is the current leader, taking over Fidelity’s spot.

target2016morn4

All Target Date Funds are NOT created the same… Consider the huge gap in possible equity percentages vs. time (glide path).

target2016morn1

…but the Big 3 TDFs are all relatively similar. Before retirement age, the glide paths are very close. They start to differ more significantly after the retirement target year.

target2016morn2

Vanguard leads the way with the highest total assets, lowest expense ratio, and the only Gold Morningstar Analyst Rating. You can feel the effect of Vanguard in that the average asset-weighted expense ratio has decreased industry-wide every single year since 2009. You can bet that this wouldn’t be the case of Vanguard wasn’t so successful.

target2016morn3

We personally have access to T. Rowe Price and Fidelity TDFs in our respective 401k plans, although we don’t own shares of either. I would recommend my own family to buy the Vanguard Target Retirement family of funds. If you own one of the lesser-known TDF families, I would download the Morningstar paper and see how it compares. You may be surprised by the inner workings.

Top 5 Retirement Savings Tips from John Oliver

John Oliver again tackled personal finance on his HBO show Last Week Tonight, this time exploring retirement savings. (He previously covered credit reports.) Here is the full video link, embedded below:

It is truly hard to present this stuff in an entertaining manner, so I was interested to see how they would approach things and who’d they pick on. It’s not bad considering it runs 20 minutes – quite long for an internet video. If you skip to roughly the 17:55 mark, you’ll get the best bits – a satirical reply to widely-promoted Prudential commercials (one, two) and his top 5 retirement savings tips:

  1. Start saving now.
  2. Invest in low-cost index funds.
  3. Ask if your adviser is a fiduciary.
  4. As you get older, gradually switch some of your stocks into bonds.
  5. Keep your fees under 1%.

Nothing new to most financially-savvy folks, but hopefully it helps steer some people in the right direction.

If The Best Investors Do Nothing, Are the Next Best on Target Fund Auto-Pilot?

tdfautoThis is becoming a recurring theme around here, but I came across an interesting tidbit in this ProPublica article on how your brain plays tricks on you. Emphasis mine:

Fidelity did a study of all their accounts to see what types of investors performed the best. They found that the best investors were the people who had either forgotten they had an account in the first place — or were dead! In other words, most investors succeed in doing the exact opposite of what they set out to do with their money (presumably, make more of it).

In other words, the best investment performance came from doing nothing. That means no buying what looks obviously good, no selling what looks obviously bad, no “taking profits”, no “taking money off the table”.

If doing nothing is best, then you should probably invest in something that encourages inactivity. That’s exactly what a Target Date Fund (TDF) does, manage your asset allocation in an emotionless manner as you age. Auto-pilot.

This Morningstar article appears to confirm this idea: Target-Date Funds: Good Behavior Leads to Better Results. Emphasis mine:

Investor returns, a dollar-weighted return that takes into account cash inflows and outflows to estimate the returns that investors actually experience, gives clues to how target-date investors have fared according to these concerns. The news is good. Whereas most other broad categories show the effects of poor timing–investors tend to buy high and sell low–target-date investors largely avoid that fate.

Investors of target-date funds tend to invest part of every paycheck into employer plans like 401(k)s, and are either (1) lazy and put there by default, which suggests future laziness, or (2) actively chose to be invested in an auto-pilot fund, which suggests they accept that inactivity on their part is a good idea. (I should admit that I did neither and use the self-directed brokerage option… but only to buy TIPS. Honest!)

There is nothing wrong with focusing on your savings rate and using the auto-pilot!

Mortgages, Imputed Rent, and Early Retirement

mcman286In a Quora question What do economists think about buying vs renting a house?, in addition to the previously-mentioned answer by Alex Tabarrok of Marginal Revolution, there was another well-ranked answer by Erik Brynjolfsson, professor at MIT Sloan. One of his three points was about the value of imputed rent (read the other ones as well):

Second, there’s a huge tax benefit to housing which comes from the hidden “dividend” it pays. I’m not talking (just) about the (too) generous mortgage deduction, but rather the fact that you don’t have to pay taxes on the implicit rent you earn on your house since its paid to yourself. A house generates enormous rental value each month — like a dividend. If you rent it to yourself, you take the money out of one pocket and pay it to the other one, and the IRS doesn’t tax that. In contrast, if you earn money some other way and then use that money to pay rent, you probably also have to pay taxes. That can add up.

From the Wikipedia entry on imputed rent:

Consider a model: two people, A and B, each of whom owns property. If A lives in B’s property, and B lives in A’s, two financial transactions take place: each pays rent to the other. But if A and B are both owner-occupiers, no money changes hands even though the same economic relationships exists; there are still two owners and two occupiers, but the transactions between them no longer go through the market. The amount that would have changed hands had the owner and occupier been different persons is called the imputed rent.

In other words, as a homeowner you could be considered both the landlord and the renter. Let’s say you would rent your house for $1,600 a month. If you were in the 25% marginal tax bracket, you have to earn $2,133 a month pre-tax to cover that rent (and pay $533 in income tax).

As part of my “rough model” of early retirement, I recommend setting your mortgage payoff date to coincide with your retirement date (for those that choose to buy a home). Part of the reason for that is that you won’t have to generate that extra income to pay your mortgage anymore. This could lower your marginal tax bracket into the next lower bracket, and also the tax rate on your capital gains.

For example, $1,600 in monthly rent equates to nearly $20,000 a year in after-tax expense, or nearly $26,000 in gross income at the 25% tax bracket. Here are the 2016 federal income tax rates (source):

2016taxschwab

Ideally, I would target my household expenses to stay in the 15% tax bracket for married joint filers in retirement. Being able to reduce my taxable income by over $25,000 would definitely help someone stay in the 15% tax bracket range. Also, if you are the in 15% ordinary income tax bracket, your tax rate on qualified dividends and long-term capital gains becomes zero!

Now, the idea of imputed income could be extended further. When I cook at home, I save the money from eating out an Applebee’s. Let’s say a dinner out costs $40 for the family. To reach $40 after-tax, I’d have to generate $53 of income at a 25% tax rate. Same with childcare, housekeeping, laundry, yard maintenance, etc. But housing is an area with significant impact, usually the biggest item in a household budget.

Reminder: Check your IRA Beneficiary Designations

iheartroth

According to the stats, you probably funded your Individual Retirement Account (IRA) at the last moment this month (assuming you fund them at all). If we tend to procrastinate about saving, then we also probably put off estate planning. One of the simplest aspects of estate planning is to designate beneficiaries of your IRA.

I am not an estate-planning attorney, but here are some tidbits I picked up from various sources including a review copy of new book The Overtaxed Investor by Phil DeMuth.

Why is this important?

  • The person, trust, charity, or estate that you pick as your beneficiary overrides any will. So if your sole IRA beneficiary is set up as your ex-spouse, and your will says everything goes to your current spouse, then your ex-spouse will still get your IRA (at least without a long legal battle).
  • If you name an individual instead of an estate, the inheritor can space out withdrawals over their (actuarial) lifetimes, prolonging the tax-deferred growth benefits of IRAs. A trust or estate does not get this feature by default (a trust may be carefully constructed to preserve some of these characteristics).
  • You may still want to pick a trust if you have sizable assets and are leaving them to young children. You can then outline rules and a trustee to manage how the money is spent. This route involves extra costs, however.
  • Secondary beneficiaries can also be chosen. If no secondary beneficiaries are named, your assets may pass to your estate – exposing them to the probate process, estate expenses, and creditor claims. In many cases, people pick their spouses as primary and their children as secondary.

How should you do it?

  • Contact your IRA custodian. I use Vanguard, and you can either fill out this paperwork kit or do it all online under Account Maintenance > Beneficiaries. They use some language to simplify the process. For example, I set my primary beneficiary as the “person I am married to at the time of my death” and my secondary beneficiary as “To my descendants who survive me, per stirpes”. I may change this later. Find out what per stirpes means and more with this Vanguard guide.
  • Keep a physical copy in your personal files. Keep copes in your home safe, safety deposit box, and/or digital safe.
  • Tell your beneficiaries where the form is and what is on it. Vanguard won’t contact anyone upon your death, so it is up to your beneficiaries to contact Vanguard. I suspect many other brokerages operate in a similar manner. There are millions of dollars in unclaimed IRAs every year.

Screenshots:

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