February 1st, 2010 | 
Author: As most of you know we recently sold our Redmond house. We now have a stack of cash sitting in the Savings account of our bank depreciating daily, and that prodded me to do some research around personal finance. I posted last week about analyzing our spending over the last year and deriving what I consider to be a pretty realistic budget. That was our first step to putting together a plan moving forward.
We have several goals. The first is to establish a reasonable plan for retirement. The second is to rein in our discretionary spending; or at least minimally track it better. Our third is to make the money that we do have work for us. Finally we want to make sure to protect against various catastrophes that might otherwise cause financial hardship/ruin.
To that end, I just finished reading Personal Finance For Dummies which I can now highly recommend. It’s a fantastic survey of the various areas that people might classify as ‘personal finance’ and I find the author to be eminently pragmatic which I appreciate. If you’re looking for a book to understand how to ‘beat the market’ this is definitely not it; this is more about understanding your options and learning what best practices are.
This post captures the set of things that Rach and I are considering implementing in the next month or so. Another goal that I didn’t mention is that I’d like to get something in place soon that we will only have to monitor minimally. For example, I have no desire to try day trading. Outside of already having a day job, I remain convinced that day trading is tantamount to gambling. I’d rather invest our money in the best way that we can reasonably figure out now and then check up on it every year to make sure that we’ve still allocated things appropriately for our goals.
Retirement
The first subject that I started looking at was retirement. Retirement means a lot of different things to different people, but to me it means not being required to work a full time job. In fact, in my current vision of the future I would still probably do part time work even after retirement, but I want that work to be optional. Our goal is to be able to retire at around 60 years old (yay for 30 more years of work!). I did spend some time crunching numbers to see whether it was realistic to retire before that… it doesn’t look good without more compromises than we’re willing to make at the moment.
The nice thing about retirement is that the government offers some nice incentives to save for it. Ever since I started working for Microsoft I’ve put 15% of my salary towards a pre-tax contribution to a 401k plan. MS has a great package that includes a certain % matched. The annoying thing about 401ks is that they have a pre-tax limit for contributions. At the moment that limit is 16,500/year. Rach and I have decided that for our 401k we will continue to contribute the max pre-tax per year. The one snag that we have to be careful of is that if you happen to make enough to hit that limit early in the year, it’s possible to lose out on some of the employer matching money. I looked around through the MS plan documentation and it turns out that it currently isn’t effecting us (yay!).
I looked into opening a separate IRA either Traditional or Roth to save a bit more, but unfortunately Rach and I cannot take advantage of any of the pre-tax benefits of those accounts because of the income limits imposed. Frankly I think it’s silly, given the mess that is retirement for a lot of people to make it hard to save, but it is what it is.
At the moment our 401k will be our primary vehicle for retirement contributions. When Rach starts to work full time, we’ll see if it’s possible to invest in any employer provided pre-tax program. I’m currently unsure whether the 16,500 limit is per person or per couple. Either way, it’s not an option for us at the moment.
Our 401k is currently split 40% in international growth stock, 40% in an index fund, and 20% in a midcap growth fund. We’ve decided that we’re happy with that allocation. Both Rach and I tend to be risk averse which is why so high a percentage is in an index fund.
In case anyone is curious, the calculators that we used suggested that we have roughly $3m dollars for retirement. Assuming consistent contributions, plus our current assets, with an estimated 8% return and 3% inflation we will get there if we wait until 60 to retire. That’s based on a lot of things that will change of course, but it’s the best estimate that we have at the moment. Note, I didn’t include Social Security in those calculations; when added if we start withdrawing money at 67 we’d be in good shape.
Emergency fund
We want to establish a well thought out emergency fund. In the past several years we’ve kept our checking/savings balance quite high (over $20k). Our checking gives us exactly 0% interest, and our savings account is currently giving us 0.25%. In short, they are well below inflation and we’ve been wasting money by letting it sit there. However, because of the high balance we have, in essence, had a nice cushion in the event of anything catastrophic happening (e.g. if I lost my job). It wasn’t at all intentional though.
The recommendations for emergency fund ‘size’ range anywhere from 3 months to 1 year of expenditures held in a very liquid ‘instant access’ account. Rach and I have decided to stow away roughly 5 months of current expenditures, though it would likely last a fair bit longer if we did have any issue since a large chunk of those expenditures are reducible.
I have had a heck of a time trying to figure out where to put that money. Our credit union offers accounts that they call ‘Instant Access’ where we could get 1.15% return. Honestly that return sucks. Instead I started looking at Money Market accounts. The major difference is that MMAs aren’t insured, and while they tend to contribute to low-risk investments there is always the chance that we can lose money with them – particularly if interest rates skyrocket when the economy recovers. This is a risk that Rach and I have decided to take. We’re considering one of two different accounts, and if anyone has a suggestion as to which would be better I’d love to hear it. We’re either going to go with the Fidelity Money Market Fund (SPRXX) or the Fidelity AMT Tax-Free Money Fund (FIMXX). This choice seems to have a lot to do with understanding the AMT and unfortunately I’m no tax expert. To date, Rach and I have never had to pay the AMT, but this year we sold a large amount of stock to cover the down payment on our new house. I don’t know whether that will affect our AMT status or not. I am leaning toward the SPRXX account at the moment.
Insurance review
One of the fascinating parts about the book I just read was that it included a section on insurance. At first I didn’t understand why that would be, but the author makes some fantastic points in the chapter. Basically, his meta point is that insurance is the way you go about making sure that you protect yourself and your family against financial ruin. He then enumerates the various types of situations which could result in ruin, and the various insurance that you can buy that helps prevent these situations. A few things that I had never considered that he mentioned:
- Life insurance is pretty pointless if you’re single with no dependents; it’s also not all that interesting to splurge on life insurance if your spouse is completely capable of continuing their current lifestyle with you gone.
- One of the most important things to cover when you’re younger is your ability to work, so it’s critical that you consider things like accidental disability insurance (workman’s comp will only pay out if you’re hurt on the job, what if you get hurt elsewhere?)
- It makes sense to get enough liability insurance to protect your assets. If you don’t have very many assets, then the default liability is fine. What if someone sues you for $1,000,000 though? If you have $500k of assets and only $100k of protection… well, you do the math. As your assets increase, it makes sense to consider higher liability insurance, potentially under an ‘umbrella’ plan.
- People pay for silly insurance. Insurance shouldn’t be used to try to smooth out every day life; if you can afford to pay a $1k deductible if you need to then get insurance that matches; only get covered for things that would be financial ruin.
- This also makes it an easy decision when asked if you want additional ‘warrantees’ on products that you buy.
After reviewing our insurance we’re covered decently well, but I plan on making the following changes:
- We had a rider on our auto insurance which pays for towing in the event of an accident. Towing isn’t expensive, and it’s pointless to insure against it. Particularly since we belong to AAA (duh!) so I’m removing it.
- We have Personal Injury Protection on our auto insurance. Our health insurance will cover both of us in the event of a major accident so this insurance is redundant for us. PIP would also cover people in our car that didn’t have good health insurance, but the fact of the matter is 99% of the time we drive each other around, and the other 1% of the time we drive folks that also have good health insurance. It’s not worth it to keep this coverage (and WA doesn’t require it).
- We are investigating increasing our liability coverage, though I haven’t researched rates yet.
- We have gone through our house and recorded serial numbers and taken pictures of all high cost items and stored that information up on a protected share in the cloud. It should significantly reduce the complexity of making a claim in the future if needed.
Additional investments
Outside of the 401k I mention above, Rach and I have a couple of other investments. In the past couple years I haven’t been contributing heavily to our employee stock purchase plan. In retrospect that seems silly. The ESPP allows us to buy Microsoft stock at a discount rate at various set times during the year. We can then sell that stock immediately if we choose and get an immediate return (minus income tax). This is an amazing deal, and we’ll be contributing the maximum to that moving forward.
After establishing our emergency fund we will still have a large chunk of cash from the sale of our previous house. We have gone back and forth about what to do with it. There are really two major options. We either invest the money in the stock market (likely a mutual fund) or we use the money to pay down the principal on our mortgage. If we had any high interest debt then the answer would be obvious, but our mortgage has a low interest rate and nice tax benefits. However, I know that Rach and I will procrastinate if we decide to invest this money into the stock market. Ultimately, we’ve decided to pay down our mortgage. It’s almost certainly not the highest return move, but I think for us it makes the most sense.
Final actions
I mentioned we procrastinate right? We still haven’t written up wills. This is something that we’re going to throw into this bucket and take care of. We’re going to write up normal wills, as well as put in place durable power of attorney.
I’d certainly appreciate any thoughts people might have on our plan, particularly if you see something that you think is jut plain wacko. Keep in mind that Rach and my risk profile is generally adverse, which means that we’re going to make more conservative decisions than other people (e.g. paying down the mortgage).
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My current investment plan is max 401k and all the rest pays off mortgage. That’s a guaranteed rate of return.
One thought for the future — what is the plan in turning saved money in your 401K into income you can live off after retirement?
The thing with a 401K is that you have to wait until you are 59.5 to start taking it out without penalty and the tax deferral can work against you if you pull out a lot of money at once — say if you want to retire at 55 or change investment vehicles to something outside of the 401K, notably an annuity.
In other words, especially in say 15 years from now, you may want to change how you save for retirement with the thought of how you are going to live off the money and minimize your tax from year to year. Putting money into the Roth 401K option can be helpful here as can a balance of after tax investments.
From your post, you will be saving in MSFT stock and your home — as your balances get high, are you thinking to diversify at all? I know I’d be too afraid to keep all my non retirement investments in just MSFT and my home.
One thought — we setup regular withdrawals to a mutual fund account and did a similar asset allocation as we have in our 401K – similar to yours with less international and a small cap component in order to have a place to diversify (and reduce volatility/risk) our after tax but still long term investments.
Did a lot of work on this, some very solid thinking here. Would encourage some diversification out of just the MSFT,although I’m sure it is very strong and the program sounds great, at least one other blue chip alternate is probably a good idea. Additionally, the idea of the will and POAs is very good, consideration of a Long Term Care Insurance vehicle would be helpful. I also love the idea of your short term emergency fund being in a Mutual fund. Most are so well diversified the potential for total or great loss is diluted. And just from the voice of experience, life changes and sometimes your best laid plans are put on hold for one reason or another. This is when faith, love and charity as well as flexibility all come in handy! Also, family!!! Love you both.
Thanks for the suggestions
One thing I didn’t make clear is that we intend to sell the ESPP immediately. After we sell it, we’ll invest it in a mutual fund outside of our 401k, though I don’t know exactly which one yet!
The roth option is a great suggestion that we’re going to look at.
Great stuff, Anson! You mentioned an accident policy. Do you have group Long Term Disability coverage through MSFT? You really should have disability protection, but not just accident protection. Its amazing how many sickness conditions are out there that no one forsees or expects that can disable people, even young people. Group protection through the employer is usually very cheap and if you have an option to opt-up to a higher percentage of coverage (60% up to 70% is common), then do it. If you have no such protection, while you are young and healthy you should look into an individual disability contract. Good carriers are NW Mutual and Standard of Oregon. If you wait until you have a health history, you could be denied coverage or have the condition excluded from coverage. Coverage is also cheaper when you are young. The advantage of an individual policy is that the premiums are guaranteed( can never be raised), the coverage cannot be dropped and you take it where ever you go. It isn’t tied to your job. You can get whatever level of coverage you want , usually up to 70% of your income and by paying the premiums after-tax yourself, you get a tax free benefit.As you were correctly advised, disability coverage is more important than life insurance in the working years. It doesn’t take much imagination to understand the effect on living if all of a sudden you can’t earn any money. I’ve seen it too many times in my career. While I agree that LTC insurance is something to consider, many experts feel that you are better off getting this a little later in life, perhaps around 50. This is a benefit that also may be offered on a group basis through MSFT. Certainly, if you were to get one or the other, disability would be the best choice right now.
Good move on paying down the mortgage. Even though the return isn’t great, the tax break I don’t think is as valuable of as having less debt. I guess we might have more conversations when you come out in June.