I met up with my lawyer buddy for donuts today and caught up on her life and updated her on mine.
She is the most frugal person I know, probably spending under $1,500/mo while living in a nice part of town, owning a car, cell phone, socializing with a decent circle of friends and mother to a large dog.
She is destroying her debt and probably will have it paid off in the next 1-2 years, a major accomplishment for being less than 5 years out of law school.
Her and I meet up once a month and brainstorm on investing, saving and retirement plans. She happens to be my only friend with as big of a sweet-tooth as myself.
We view our jobs the same way, the intellectual work is really interesting but there is way too much fluff that comes with it. She would like to pursue something else once retired without having to worry about how much money it’s going to make her.
Our plans over the past couple of years that I’ve known her have changed a little. She has decided to attack and get rid of all her student loan debt after I did the same. And I have been trying to curb my spending and enjoy a similar lifestyle she does.
Today we both reached a similar conclusion after talking a bit. We are going to treat our taxable and tax-deferred savings separately. Let me tell you how that’s gonna work with my stash.
In my taxable accounts I have somewhere around $80,000 and in my tax-deferred there is currently $340,000. Real estate makes up the other $150k.
The tax-deferred portion has the advantage of being able to grow tax-free. But it’s called tax-deferred because the taxed are pushed off into the future, upon withdrawal, usually after age 60.
My funds are mostly invested in mutual funds and so there are dividends every quarter which technically are considered income. Because of the IRS classification of such accounts (401k, IRA, Roth, 403b, 457 etc.) they can earn dividends and earnings through sales of appreciated funds without incurring any taxes.
My plan is let this money grow without touching it until age 59.5. This is the age at which point I won’t be penalized for accessing the money. As of this writing, 2016, the IRS will hit me with a 10% penalty if I withdraw before that age.
Once I turn 60 I will have to pay income taxes on any portion of the money I withdraw. Basically, the withdrawal is treated like income. If I have $500k in my IRA and take out $30k from it in retirement I would have a $30k income for that year. However, I am betting that income tax brackets won’t change much for those in the lower income needs – that’s where I’ll be as long as I keep my overhead low.
If my funds grow to $1 million and I take out only $30k/year I will likely owe in the 10% range as long as I play the write-off game.
Depending on how much longer I stay employed by a company offering a 401k or other retirement plan benefits I will continue to contribute to my tax-deferred retirement stash.
Left to grow without pillaging that account I would have around $1,260,000 by age 60.
Go to the online Money Chimp calculator and play around with your numbers. Enter how much you have saved up, enter the number of years that you will let it grow, and the percentage at which you expect it to accumulate. You can disregard the # of times compound interest will accumulate.
If I remain employed those next 22 years or start my own business and establish a solo 401k or SEP IRA then I could contribute the current 2016 max of $53,000 per year or at the very least $18,000.
With an annual addition of $18k annually I would end up with $2 million by age 60 with a conservative rate of return of 6%.
My taxable accounts function in a very similar fashion. They are also invested in mostly mutual funds. Because they aren’t held in tax-advantaged accounts the dividends and earnings on sales of appreciated funds will trigger a tax event.
Which means that every year when I get the ~2% of dividends deposited into my investment account I would end up owing taxes on that. Those tax events generally aren’t as highly valued by the IRS so they aren’t taxed as highly.
That’s when you hear the terms qualified dividends vs non-qualified dividends, used in the former for lower taxed earnings and in the latter taxed similar to earned income (sucky).
The above is a snapshot of my REIT account at Vanguard. I have around $20k in that account. Every 3 months I get a certain percentage deposited in forms of dividends into my account. My account is made to reinvest those dividends automatically and buy more shares with it.
It’s important to note that even if the value of my account goes down I still get a dividend deposit… not too shabby.
Back to the taxable accounts. My goal is to steadily add to this bucket, currently at $80k, with the goal of getting it somewhere into the $300k range.
This is the account from which I will spend dividends or sell appreciated funds in order to generate income when I decide to no longer work.
2% dividends on an investment account worth $300k would be $6k a year. Enough to cover almost all of my grocery and housing expenses.
Taxable accounts are much easier to access than retirement accounts (tax-deferred). Yes, there are fairly straight forward ways of accessing the latter but there are some headaches which I have discussed in other posts, and here.
So my lawyer buddy and I, over those delicious donuts, decided that we would continue building up our taxable accounts. Even once they hit the maturity value we are each aiming for we are likely to continue working, earning income. So we may continue contributing to them and making them grow.
But I’ve mentioned before that once I establish my own financial security I would like to do bigger and better things with my money. I have a few good causes that I could contribute to and projects which I am interested in being part of. If I run out of things to do then I want to help out my friends and family with their financial burdens.
Spending from a taxable account invested in mostly low-cost mutual funds growing at somewhere around 5% per year I could expect to generate around $12,000 after taxes from a portfolio size of $300k (2% of dividends and 3% from sales of appreciated funds).
Some years when the market is doing really well I may be able to withdraw 8% and some years I may have to sell more funds in order to meet my minimum overhead.
Some people are averse to the idea of selling their funds, that’s fine. You can set up your account so that dividends aren’t reinvested and instead deposited into your checking account.
Whatever money you make from the dividends may be enough to live off of, and if not you can always supplement it with some side income just so that you don’t have to sell off any funds.