Saturday, December 30, 2006

Net Worth and Retirement Saving Status, 2006 Year End

As discussed in this post, I'm reporting my net worth in terms of months of spending. So here goes:

  • Non retirement account savings --> 20.46 months
  • Tax-deferred retirement savings -> 79.37 months
  • Roth IRA retirement savings------> 11.30 months
  • Total --------------------------> 111.13 months
Based on current savings and Social Security credits and subtracting estimated taxes, I estimate my income in retirement based on retiring at the following ages, and stated in terms of replacement of current spending:
  • Age - Current Spending replaced
  • 62 ---- 73.44%
  • 66 ---- 90.63%
  • 70 --- 112.64%
Again, this is based on savings to date. With future savings, I'd like to get the replacement rate well above 100% before I retire, to provide margin for changes in spending for things such as health care and lifestyle changes -- I might want to travel more. I have a few more years to improve these numbers. By the time I reach the age of 62, I expect to be able to have the spending replacement for that age over 100%, provided I can maintain my current savings rates and the stock market doesn't crash.

Friday, December 29, 2006

Net Worth Benchmarking

The authors of "Millionaire Next Door" recommend that your net worth should be determined by the following formula:

Proper Net Worth = Age times Annual Income divided by 10.

I have a few problems with that formula. According to that formula, if I had the proper amount saved but got a promotion and a higher salary I would suddenly be deficient in my savings. A 20-year-old with an associate's degree and just starting his career needs to suddenly have 2 years income saved up. A 30-year-old medical doctor with a huge student loan debt is even further behind the curve.

Another issue I have with the formula is that a significant portion of most people's net worth is the equity in their home. To get at the equity in your home, you have to sell it. And not all of the supposed equity is yours, as there are real estate commissions and other costs with selling your home. And then you have to pay to live somewhere, unless you can find a nice comfy bridge that isn't already occupied to live under. On the other hand, there is some advantage to having the mortgage retired when you are as it reduces your expenses.

The net worth statements I see in the blogosphere also make no distinction between money in a tax-deferred retirement account and any other kind of balance, adding their 401k balance directly to the asset side of their balance sheet without any corresponding tax liability.

A better net worth benchmark would be based on the type of education you have and how many years since you completed it. More importantly, it would not be based on your income but rather your spending. Someone with $2M at retirement would usually be in good financial shape. But not if he had Bill Gates' lifestyle. I imagine the taxes and upkeep on his mansion would easily absorb that in a year.

I plan to report my net worth not in dollars but rather in months of average spending. That provides a better picture of whether my net worth is appropriate for me (not Bill Gates), and will provide a small amount of privacy should my identity be determined.

"Average spending" will be determined by over a fiscal year, subtracting from total income the amount of income taxes and other withholdings from my salary and the amount of any money I've set aside for retirement during the year, whether in a tax-advantaged retirement account or not. Average spending will then include actual expenditures as well as any money I save for nearer term goals, such as savings to pay taxes and insurance, replace my vehicle when it wears out, or for maintenance on my home.

I plan to report the following in units of months of average spending:

  • Emergency fund and long term savings held outside of retirement accounts
  • Tax-deferred savings, after subtracting the combined effect of my marginal federal and state income tax rates
  • Roth IRA balances, no adjustment for taxes needed.

What won't be reported:
  • Liabilities. My only liabilities are credit card charges from the current billing cycle, which I pay in full when billed. These liabilities are more than offset by assets which I don't report.
  • The value of my household items. Really, how much could I get for them if I held a garage sale or put them up on eBay? I may spend 99% more time figuring out my net worth than the average person does, but I've got better things to do than making an inventory of my silverware.
  • My house and vehicles. After all I'm using them and if I sold them I'd have to replace them as they wore out. Since I have no debts and therefore no payments, my spending is reduced, at least on the home which I expect to last my lifetime, so if I reported its value I'd also have to add imputed rent to my spending. If I did decide to report the value of my personal property, it would be a conservative value of my home and cars.
  • The value of my near-term savings, used for replacing and repairing my vehicles, repairing my home and replacing furnishings, paying property taxes and insurance, and money held just for handling monthly cash flow.
Instead of benchmarking based on my current age, instead I'll estimate my retirement income at three different ages (62, 66, and 70) based on current savings and current Social Security credits and subtract income taxes at today's rates, and report what percentage of my current spending would be replaced. Income from savings is determined by subtracting age at retirement from 100. I won't be adding inflation between now and when I actually achieve that age, but rather reporting in terms of today's spending. This assumes that my investments will keep up exactly with inflation.

There are some deficiencies in this method. For instance the cost of medical insurance. Or long term care. Although some of this is offset by the fact that I'm not considering the value of my home, which could be used to cover long term care costs. Also that my spending could change somewhat in retirement. But I have to start somewhere, and I think current spending is a reasonable approximation of retirement spending.

Thursday, December 28, 2006

Roth Vs Tax-deferred Retirement Savings

Even before blogging became popular, Humberto Cruz has been writing on personal finance in his Savings Game column syndicated in many newspapers. He pointed out in a recent column that if you're in the same tax bracket now as you will be in retirement, there's really no tax advantage between saving in a Roth IRA and a Traditional IRA. For example, someone in a 15% tax bracket would have the same money remaining after paying taxes later-on at a 15% rate on $1000 + compounded earnings as he would paying $150 in taxes on $1000 now and collecting the remaining $850 plus the compounded earnings tax free from a Roth IRA account.

All other things being equal, I agree completely with this. The analysis is absolutely correct. However, the Roth allows you to effectively put more money in tax-advantaged savings. Provided you can come up with the money to pay the taxes this year, then instead of contributing your limit to a Traditional IRA, contributing the same amount to a Roth IRA would let you pull the higher amount plus compounded earnings out tax free in retirement.

However, the tax code is complicated and there are other considerations. So "all other things" are not always equal. While you could be in the same tax bracket in retirement, you might effectively be in a higher tax bracket.

In future posts I will be discussing the possibility of a higher effective tax bracket in retirement and how I am dealing with it.

Saturday, December 23, 2006

Do I use Quicken or Money?

The answer to the title question is: "No." I use a spreadsheet to track my finances.

I started out when much younger by tracking my finances with paper, pencil, and calculator. I divided my income into categories in sort of an envelope system. Each payday, I added the budgeted amount and then tracked spending in each category. When Visicalc came out, I switched to using that. For those of you too young to remember, this is one of the first spreadsheet programs.

Later on, I stopped tracking many of the minor expenses such as groceries and food but continued to track major expenses such as mortgage payments and tracked to ensure that savings goals were being met. Having previously developed good spending habits while closely tracking expenses, I was able to manage without the effort of tracking details.

Instead, I began using spreadsheets to look at other aspects of my finances, such as tracking my mortgage balance and estimating my retirement. Tracking my mortgage paid off, because I discovered that the mortgage company was charging interest for an additional month on extra payments I was making against the principal.

I also use spreadsheets to calculate my taxes. My taxes aren't that complicated, but I do fill out more than the short form. I find tax calculation spreadsheets simple to set up, and the flow goes in this order:

  1. Schedule B
  2. 1040 side 1
  3. Schedule A
  4. 1040 side 2

My system includes tracking savings for goals of different time frames. Near term goals for me include making sure that I have enough set aside to make insurance and property tax payments as they come due in the next year -- since I've paid off the mortgage I have to do that myself. Long term goals are adequate retirement savings. Intermediate goals are setting aside money to buy the next car and setting aside money for major repairs to the house.

I have tried out both Quicken and Money. I didn't have the patience to go through all their questionnaires. I prefer to use the system I have -- the engineer in me likes to understand how some of the projections are done, and I disagree with some of the calculators I run into on the 'net.

I would not recommend my approach for someone who is having financial difficulty and/or is not setting enough aside for the future. That person needs to closely track their expenses so s/he can figure out how to get spending below income. Nor would I recommend it for someone who has trouble with math, or setting up a spreadsheet.

Thursday, December 21, 2006

Pay Debt or Save for Retirement

The anonymous blogger over at "My Retirement Blog" discusses this issue .

That blogger gives the example of John Smith, who has mended his spendthrift ways but has a $25000 debt at 15% interest to handle. His employer offers a 401k plan with dollar-for-dollar matching up to 3% of salary. The advice on the other blog is to pay off the debt first before contributing to the 401k plan because the $3750 in interest exceeds the amount that could be obtained from a company match on 3% of salary for those making less than $125K/year.

That math-challenged blogger obviously never graduated as an engineer, or any other profession requiring math skills. It's illogical to give up the 100% immediate return from the company match for a 15% return from credit card debt. Yes, I know that tax considerations can narrow the difference a bit, but not enough to overcome the difference between 100% and 15%. If John Smith is close to retirement and has no tax-deferred savings, he might not pay any taxes at all if he keeps his annual distributions low. Let's take a closer look at the numbers. I use spreadsheets to perform this type of analysis.

In order to save the $3750 in interest over the next year, John Smith need to have $25K in hand to immediately pay off the credit cards. If he did, then what's the problem? Pay off the debt and then participate in the 401K.

To round out the scenario a bit more realistically, let's say John makes $100K per year and has trimmed his expenses so he can devote $2000/month towards improving his net worth. If he applies it all to the credit card debt, after 12 payments he has reduced the balance to $3298, improving his net worth in one year by $21701, and spent $2298 in interest. So John didn't eliminate $3750 in interest payments but reduced it by a good deal.

On the other hand, if he participates in the 401K plan to get the 3% match he reduces the amount he can pay towards the debt not by the $250/month contribution but by less than that because taxes are not taken from the contribution (yet). Say John's marginal combined federal and state income tax rate is 30%. The $250 contribution reduces his take home pay by $175/month. By paying $1825/month ($2000 less $175) against the credit cards, he reduces the balance over the same one-year period to $5548, improving his after-tax net worth by $19451, and spending $2448 in interest.

By participating in the 401k, John's after-tax net worth is $2249 less after one year than it would have been had he applied the entire $2000/month to the credit card debt. But much more than offsetting the $2249 is the $6000 plus any earnings in his 401k account. Yes, John has yet to pay taxes on that money but his tax rate would need to exceed 62% to offset the difference.

The only scenario where it makes sense to pay off debt before participating in a 401K with a 100% match from the employer is if the interest rate on the debt is much, much higher. If John had payday loans, I would recommend he pay them off first.

Priorities should be (in descending order):

  1. Make minimum credit card payments and build up a small emergency fund, say $1000.
  2. Contribute to your 401k to get the company match, even if the match is only 50 cents for every dollar.
  3. Pay off high interest credit card debt.
  4. Contribute the maximum to a Roth IRA, and build up your emergency fund to at least 3 months expenses. In John's case I'd slow down paying on the credit card debt after knocking the balance down and fund a Roth IRA for tax year 2007 by April 15, 2008. Reason being the opportunity cost of not contributing to the Roth IRA.
  5. Consider longer term savings options, such as increasing your 401k contributions if you are close to retirement and have a low balance, or paying a bit ahead on your mortgage if you plan to stay in your house after retiring.

My engineering mindset led me to analyze this a bit deeper than a shot from the hip as the other blogger apparently did, and I came up with a better answer.

Blog Introduction

I've been reading personal finance blogs for some time, and I decided to start one of my own.

Having been born in the mid 50s and also being in my mid 50s, my focus is preparing for retirement while keeping my eye on short term activities. An engineer by profession, I may sometimes analyze finances a bit from that perspective.