This article was written by MP Dunleavey for Betterment.com.
It's finally happened: You've landed a $2 million windfall -- from an IPO, inheritance or selling your screenplay -- the kind of money you always dreamed of.
Can you afford to quit your job? Is this the moment for an early retirement?
We talked to Jeremy Jacobson, 39, who retired a year ago thanks to the nest egg he and his wife saved for 10 years. They have no plans to rejoin the workforce, because they expect their money to last another 60-plus years. They even want to have kids.
Is this plan realistic -- or even smart? We analyzed Jacobson's strategy for financial independence, and compared it to a more conservative view from wealth advisor Steve Merrell, co-founder of Monterey Private Wealth in Monterey, CA.
If your strategy is built around a modest drawdown rate, minimal taxes and harvesting gains, it's not only possible to keep your windfall growing while you enjoy a better quality of life -- you may even be able to aim for an early retirement like Jacobson's.
In fact, while neither Jacobson nor Merrell is affiliated with Betterment, both of their methods for sustaining a windfall are predicated on generating steady returns for many years, with minimal effort and stress -- which is what the Betterment portfolio is designed to do.
Scenario #1: Total financial independence
Jacobson was in his mid-20s and working as an engineer at Microsoft when he decided that total, long-term financial independence was his goal. And he knew it would take about 10 years to achieve it.
He and his wife saved between 50% and 70% of their income for a decade. They lived modest lives on good incomes, he says, choosing to minimize the three expenses that are dominant for most Americans: housing, food and transportation.
He declined to reveal how much they saved in total, but our estimate (based on details he discussed in several emails and an interview) is that he has at least $1.2 million in his portfolio.
Make your money last
Jacobson also did a lot of research (see the reading list below). One guiding principle that emerged from his self-education was the 4% rule, he said, referring to a common rule-of-thumb for "safe" asset decumulation, especially for retirees.
A $1.6 million portfolio earning 7%, could grow to about $12 million in 30 years, pre-tax -- you could reach that goal by investing in a 70-30 Betterment portfolio.¹
Minimize taxes
As U.S. citizens and residents of Washington State (although they're traveling in Mexico now), Jacobson and his wife Winnie Tseng pay federal, but not state, taxes. Jacobson figured out that the first $20,000 of your income is tax-free if you take the standard deduction and personal exemptions of $3,800 each. By keeping their marginal tax bracket low, they could also claim up to $70,700 in dividends and long-term capital gains tax free.
Thus, they could live on about $90,000 tax free -- but they choose not to. "Our lifestyle requires about $850,000 invested," Jacobson says. Currently, his financial plan requires that they live on 4% of that, a bit less than $36,000.
In addition, they rely on tax-gain harvesting. They take about $30,000 per year in long-term capital gains, and reinvest those to raise their basis and keep their investments growing -- also tax free. His example:
You buy $100,000 of Microsoft stock at $100 a share. Hold it for a year and sell the stock for, say, $130,000, which yields a tax-free gain of $30,000.
You'd then buy $130,000 of, say, Berkshire Hathaway, hold that for at least a year. Once you sold BRKA, your new basis is $130,000, so that $30,000 remains tax-free forever.
Spending vs. growth
But it takes more than tax planning to make your money last. Jacobson and his wife are comfortable for now, traveling in countries that allow them to live an affluent lifestyle for a much lower cost of living than in the U.S.
That lifestyle might not appeal to many investors (see Scenario #2, below), but Jacobson's low-cost, itinerant path is allowing his money to "bloom," as he puts it. By one analysis (he uses this calculator), there is a 20% chance that he could end up with $85 million in 30 to 40 years, and a 50% chance it could top $30 million. "I'm OK with that," he says.
He's also weighing a shift to an all-stock portfolio, despite the additional risk involved.
"Today we are at roughly 70% total market stock fund, 15% mid-term bonds, 15% REITS, plus individual dividend-paying stocks," Jacobson says. He's considering reducing the bond portion of his portfolio a) to lower his taxable income and b) for the promise of greater long-term growth.
"If we invest all in stocks, we should be able to leave behind a bigger endowment," he says. "This could be the difference between funding a small charity hospital in one town and funding a nationwide family of charity hospitals."
It's hard to offer advice to a guy like Jacobson on how to run his finances. He clearly has his situation under control. But if you've got less time on your hands and want to benefit from a diversified portfolio with the ability to seamlessly adjust your exposure to stocks versus bonds with no trading fees -- with similar results to his current strategy -- that's what Betterment is here for.
Scenario #2: Using a windfall to boost quality of life
Wealth advisor Steve Merrell offers a more cautious plan for dealing with a windfall of $2 million -- an amount he believes would not allow most people to quit their jobs.
While he doesn't rule out the possibility of an early retirement, Merrell suggests running the numbers and projecting your cashflows in order to plan for contingencies -- everything from kids to school costs to a possible setback like an illness or accident. "You'd want a pretty firm grounding before stepping off the track completely."
Merrell thinks a smarter way to handle $2 million is to consider it as life-long supplementary income, by using part of it to create an annuity of sorts by withdrawing, say, a 20% chunk to generate extra income over time and setting aside the rest. By annuitizing part of your windfall, in effect, "it gives you more freedom to do what you're already doing, then you can make other choices about your life," Merrell says.
We wrote about how to create a happiness annuity from a windfall, and Merrell's strategy is similar -- with the added benefit that by not touching 80% of your stash, you'll end up with substantial wealth by the time you retire.
The question you want to ask of any portfolio is: Do I want to keep that money working for me, or do I want to spend it? "It could be the difference between the Volkswagen now versus the Ferrari later," Merrell says. That's the beauty of compound interest. "Simple returns are very modest compared to what compound interest can do," he says.
For example, if you kept $1.6 million of your $2 million invested in a diversified portfolio, you have various options with the remaining 20% ($400,000). Let's say you put that $400,000 into tax-exempt bonds, with a yield of 2.5%. That's a modest bump of about $800 per month or about $10,000 a year, tax-free.
Or, assuming you're 35 and plan to retire at 65, you could spread that same $400,000 over the 30 years of your remaining working life, and enjoy an additional $19,000 a year, in which you'd spend down the full $400,000.
Either way, if the $1.6 million portfolio that you set aside is earning 7%, it is expected to grow to about $12 million in those 30 years (pre-tax), Merrell estimates. An investor could reach that goal without resorting to time-consuming DIY efforts: i.e. by investing in a 70-30 Betterment portfolio.¹
Depending on your financial plan, tax strategy, and lifestyle, financial independence could be within your grasp, as Jeremy Jacobson's story shows. Or, you could opt for a more traditional route with arguably less risk--and possibly less reward.
Now all you need is the windfall.
Reading List
As Jeremy Jacobson was crafting his financial strategy, his research included several well-known books, blogs and other resources:
• Your Money or Your Life
• The Four Pillars of Investing
¹You can read our full returns disclosure here.
Betterment is the smarter and most trusted automated investing service that helps people to better manage, protect and grow their wealth through leading technology. The service offers a globally diversified portfolio of ETFs, designed to help provide you with the best possible expected returns for retirement planning, building wealth and other savings goals. Betterment is a CNBC Disruptor 50 and Webby award-winner and has been featured in the New York Times, Forbes and the Wall Street Journal. Betterment helps people to achieve a smarter financial future with minimal effort and at a fraction of the fees of traditional financial services. Learn more here.
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