72(t) SEPP withdrawals for early retirement

In my neverending quest to find the best way to save for retirement, I've given some consideration to the 72(t) SEPP (substantially equal periodic payments) provision that applies to IRAs.

Basically it works like this. The 10% early withdrawal penalty can be waived, at any age, if you start taking substantially equal periodic payments designed to last the rest of your life. These SEPPs have guidelines set by the IRS, and you must be careful when you get one set up to assure that you don't get penalized for not following the guidelines.

Here's the cool part-- when you hit 59 1/2 or have been taking SEPPs for 5 years (whichever is LATER), you can stop taking SEPPs and withdraw the money at your discretion without penalty. So you can use SEPPs to help fund your early retirement, then when you hit 59 1/2 you can alter your plan to withdraw based on your needs instead of a formula. This enables you to fund both your standard retirement and any early retirement period entirely within the confines of an IRA-- giving you the tax benefits and still allowing you to take funds out before "retirement age."

How much are these SEPPs going to give you? Great American Financial Resources, Inc. has a nice calculator that will give you some idea of what one of these looks like. They also outline the rules, in layman's terms, for setting one up.

This changes the game a little bit. You now have a considerable number of options to fund early retirement: withdrawing Roth contributions, building up taxable assets and just paying capital gains taxes, or building an IRA and rolling your 401k assets into it, then setting up SEPPs. Depending on the size of your SEPPs, you may need to do more than one of these. Then when you hit 59 1/2, all these assets are fair game! Access them at your leisure, only paying applicable taxes and taking no fee hits.

My mind has been a roller coaster ride over all this research . . I've crunched way too many numbers and read way too many articles. But with the 72(t) SEPP option, I think the picture is becoming a little more clear. The best part is that conventional advice-- maxing your IRAs and 401ks-- remains applicable even if you plan to retire early. This is NICE, as it makes saving considerably less complicated.

Now that everything seems totally clear, I expect to read something in the next few weeks that confuses the issue further. But hey, early retirement wouldn't be nearly as fun as a goal if it were a stationary target. :-)

What will I do when I retire?

I was talking about my pappaw over the weekend, telling my girlfriend that he retired at 55. Of course, she asked, "what has he been doing for the last 30+ years?" I don't really know. He likes to garden, has rental property to take care of, and has been involved with the American Legion, but that's not nearly enough to fill so much time.

It got me thinking. I have this preposterous goal of retiring at the age of 45. I think it's doable, as in, I think I can have the money to pull it off. But what will I do with myself? That I don't know. If I plan to live it up-- travel, recreation, etc.-- then that will raise my required withdrawals considerably. If I don't plan to "live it up," I really don't know what I'll do with myself. I can't imagine finding enough hobbies to tide me over for 40 years, if I should live that long.

So I guess maybe I should figure in some pretty serious expenses-- a couple of long trips every year, perhaps . . . the cost of several rounds of golf per week . . . tickets to sporting events . . . the list would go on. I would be spending much more on recreation than I am now, but nothing on retirement savings, of course. In the end the two may cancel each other out, and my retirement expenses would be about the same as my expenses now. But you have to figure healthcare will be a major expense, and the cost isn't going down anytime soon.

So in my figuring, I should probably think about requiring withdrawals LARGER than my current income. I haven't run the numbers yet, but I've got to think it's going to set me back-- perhaps to the point where retirement at 45 is not realistically possible. This is okay, as it would solve my "what to do with myself" problem for the first 5 years or whatever it takes to make the numbers jive. And hell, retirement at 50 is still pretty damn sweet.

I'm rambling, but the point to take away from this is that when you assess your finanancial goals, you have to really put together a picture of what you want to do. Without a good understanding of that, your financial picture doesn't mean much.

Drink water, save $46,000

The "latte factor" has been well documented in personal finance circles, but I thought I'd bring you another example of the effect . . . this time revolving around dinner beverages.

Suppose you are 25 and going out to eat, though expensive in itself, is something that you like to do and don't want to give up in order to be more frugal. Suppose also that you go out to eat once a week (we go out more frequently than this, unfortunately). How often do you order a soft drink, tea, or other beverage? For many people, this is just part of their meal. They get a Coke or a tea or some other favorite fountain drink. How much is this costing them?

Let's assume the drink is $2, which is on the low side for a sit-down restaurant. Ordering water instead will save you $2 per meal, once a week. Starting on your 25th birthday, you save this $2 every week, and at the end of the year, invest it in an index fund. Over the next 40 years, your money ($104 each year) grows at 10% annually. How much of a difference does this make to your retirement fund?

$46,029.

Wow! Opting for water instead of a soft drink can add more then $46,000 to your retirement fund.

Let's play with this a little more. Suppose you're a beer drinker, and at your weekly dinner you usually order 2 beers instead of a soft drink or water. Most places, a beer will cost you $3 or somewhere north of there. Let's assume $3, for a total of $6 per week. How much would the practice of ordering water instead add to your retirement fund at 65?

$138,089.

What if you like fancier beers @ $4 a pop?

$184,119.

What if you like to get a couple of glasses of wine instead-- nothing fancy, just a house wine-- at a rate of $6/glass?

$276,178.

More than a quarter of a million dollars for 2 glasses of cheap wine per week.

To me this illustrates 2 very important points. One is the power of compounding . . . you're putting in just $624 per year from your wine savings ($24,960 total), and when you hit 65 it's worth $276,178.

The second is how much of an impact your small spending/saving/investing decisions make. $2, $6, $8, or $12 may seem like very little compared to your salary or your portfolio value, but over time, I think we can all agree . . . $46k, $138k, $184, $276k . . . not small potatoes.

I'm guilty of straying from this pretty frequently . . . particularly for beer. But I try hard to avoid it, since beer in the store is SO MUCH CHEAPER than beer in a restaurant. I try to drink water with my meal, then go home and have a couple of beers at less than $1/bottle. Seeing the impact of decisions like this on my financial goals is a bit of an eye opener . . . one that you know is true, but when you see it in print, really smacks you in the face. Also keep this in mind-- if you like more expensive drinks or drink more of them, or if you go out to eat more than once per week, the magnitude of your decision is even greater.

So give it a shot. Start drinking water and earmark your savings for deposit in your Roth IRA. Your retirement will thank you!

Invisible fencing for the frugal pet owner

In October, my girlfriend and I got our first puppy. We went down to a local animal shelter, where we were lucky enough to find an adorable little beagle/rat terrier mix, just 6 weeks old and less than 4 lbs. Three days later we took him home, and we've been so thrilled to have done it. He's about 8 months old now and is leveling off at around 23 lbs.

For most of his life, he's had a small area outside, essentially made with heavy chicken wire, where he could be let outside to do his business and play. The area was about 120 sq ft of patio and maybe 40 sq ft of grass . . . not nearly enough for a now full-grown pup! We would take him to the dog park and to play with his pals at their houses, but for the most part he just didn't have enough space.

After weeks of discussing and arguing about the cost (that was my angle) / benefit (that was her angle) of a new fence, we got an estimate for a wood fence-- about $4000. Neither of us was going to be happy spending $4k, especially in a house that we're in for the relatively short term.

In the end, we made the decision to go invisible-- specifically, we picked this kit up at Home Depot for $140. Four days and about 10 hours of burying the wire later, we had a functioning invisible fence, and we started training Bruno on it right away.

It's amazing! It is truly is remarkable how quickly he has learned his boundaries. He has gotten zapped 4-5 times, but now he's very careful around the boundary and listens for the beep-- and when he hears it, he immediately backs off. We've let him know that inside the boundary is a safe zone by playing with him consistently after he tests a boundary, and it seems to have paid off. He immediately turns and comes back, never giving a thought to continuing through the wire.

The cost difference is tremendous, and there are some additional benefits to invisible fencing as well. For one, we could snake the wire around a flowerbed in the back to make it off-limits, and it would have made no sense to do that with a real fence. Also, the back yard still has a very open feel, which we would have lost with a wood fence. When we eventually move, we can take the base and collar of the system with us, and we'd simply need to buy new wire ($30/500 ft) to install it at a new location.

So there you go. $140 vs. $4000, and we can take most of it with us. In the end, we are both happy, and Bruno is completely thrilled with his newfound freedom. Sometimes the best decisions are also the most cost efficient.

Some links of interest

I've been doing some reading this morning and thought I'd highlight some posts that I enjoyed . . .

• JLP of AllFinancialMatters shows why investing in the stock market should be a long-term strategy. Great post! What fascinated me is how lousy some of the periods involving the 1970s were . . . I knew none would be negative, but with inflation they got pretty damn close.
• Jim at Blueprint for Financial Prosperity asks, is Zecco a scam? He seems to be leaning toward "no" as his next entry is about opening his Zecco account. :-) As for myself . . . I'm pretty skeptical. I don't trade much, so for now I'll play it safe and stick with Scottrade.
  
• James of DINKs posts something I very much disagree with-- that smart people should not be using credit cards. I think what he is really arguing is that most people can't handle it, so most people shouldn't try. Those of us that are a little more responsible and savvy can use them to our advantage.
• Teri at PFadvice warns us that we may be in a higher, not lower, tax bracket in retirement. This will certainly apply to some people . . . and it just raises the argument for the Roth IRA and 401k even higher. Take the lesser tax hit now and enjoy not paying them later!
• Plonkee talks about randomness and insurance-- and why it's important to consider the consequences of a bad event, not just the probability. This is a great point! If my odds are 1 in 1000 of losing my job in the next year, that doesn't seem like a big deal. But 1 in 1000 type events do happen-- and if this one did, I better be prepared for the consequences. In some cases, this means buying insurance.
• Kevin at HealthyWealthHappyWise makes a great post about frugal computing . . . save money by using Ubuntu linux. Actually, frugality is but one of several reasons to do this, as Kevin explains. I've used Ubuntu before and he is right . . . it's much easier to make this transition than with other linux distributions. Anyone can do it!
  

Great posts abound in the PF blog universe. Thanks for the good reading.

The disturbing side of my net worth growth

I have to say that I'm thrilled with how quickly I'm progressing toward my annual net worth goal. It was an aggressive goal and it looks like I may meet it early (though the market taking a bit of a dive right now is not going to help).

But there's a downside to this. Let me explain. I've been tracking my net worth for less than 4 months and it is up 20%. That's a fast pace, and it has been driven 2/3 by savings, new investments, and debt reduction-- so it's not like it's all about the market. Anyway, if you take that rate of growth back in time, just a couple of years ago I would have been near zero. That wouldn't be a big deal if I were at zero or if there was some reason for having a low net worth that changed only recently.

But there wasn't. When I finished grad school, I had no debt and a good job. My net worth was already positive. That was 4 years ago . . . what the hell did I do with my money for the first 3 1/2 years ? It sure wasn't growing much. If I can grow my net worth this quickly, it just casts a major shadow on my financial life for the first few years after I got out of school. It makes me wonder . . . what would my NW be if I was this diligent upon graduation? Double what it is now? Perhaps. THAT is a depressing thought.

It is also a stupid thought because there's not a damn thing I can do about it now. I made my mistakes and now I just have to do my best to move on and do better. It could be worse . . . much worse. Some people are 40 or 50 before they come to their senses about finances. Some people never do. I only wasted 3 1/2 years or so, and even doing that I didn't get myself into trouble (credit card debt, excessive spending). I just wasn't saving and investing like I should have been.

It troubles me when I think about it, but I'm going to try to just forget about it. Spilled milk and all that. Most of us have to do this from time to time; make a mistake, learn from it, and then just forget about it. Letting it linger is not going to do any of us any good.

So, on to better (and hopefully much, much bigger) things. But I thought I'd share because we've all kicked ourselves (perhaps a little too much) over mistakes that just ought to be dead and buried.

Roth 401k: optimal vehicle for early retirement?

I've been giving early retirement a lot of thought lately. Specifically, I've been trying to figure out which investment accounts can be best used for this purpose. Should I throw money into a taxable account, paying only capital gains taxes when I need to sell some for income? Should I put it in a Roth IRA so that I can withdraw contributions tax- and penalty-free before I am 59 1/2? Should I put it in a 401k and take the 10% penalty when I need to withdraw some?

One thing, to me, is obvious. The Roth IRA is the best solution. It beats the taxable account hands down, essentially eliminating the capital gains tax as long as you only withdraw contributions. It also beats the 401k (on which you would pay ordinary income taxes plus 10%) in most situations. But there's a problem here; you can only shelter so much money in a Roth IRA each year. Currently it's $4k, soon to increase to $5k. If you plan on retiring very early, say at the age of 45, it's unlikely that you could have built the Roth IRA up enough to support you until "retirement age."

The Roth 401k is a solution to that problem. The limits on the Roth 401k are just like the traditional 401k-- in the neighborhood of $15k per year and set to increase in the future. Contributions are also after-tax, meaning you can contribute more overall than in a traditional 401k (considering the front-end nature of the Roth taxes). Withdrawal rules are similar to the 401k, so you have a 10% early withdrawal penalty as well as mandatory withdrawals at age 70 1/2. But just as you can rollover a 401k into a traditional IRA, you can rollover a Roth 401k into a Roth IRA . . . and in the process you can circumvent these withdrawal restrictions. As long as you wait 5 years to withdraw funds, you can withdraw contributions from the rolled-over Roth 401k tax- and penalty-free. In essence, the Roth 401k allows you to increase your contribution limits on your Roth IRA, from a paltry $4k per year to a hefty $19k per year, getting you much, much closer to being able to support a long early retirement. You simply have to do a timely rollover when you leave your job.

This is a phenomenal tool, and one that most companies to date are not offering access to. Fortunately mine is-- and I am about to change my deferrals to take advantage of it. As long as the government keeps its promise and does not tax Roth withdrawals, the Roth 401k will be the ideal tool for preparing to retire early.

My home as an investment: solid returns after 2 years

It seems, every week, there are a lot of PF bloggers talking about renting vs. owning, and it's a subject I love to comment on. This morning I read Real Estate Isn't a Gimme on Money Musings, a post referencing a David Crook article on Yahoo! finance.

It all got me thinking about my house, how much has gone into it, and how much I'd get out of it if I sold right now. I decided then to make a spreadsheet, add up all my payments, maintenance costs, small improvement projects (that I wouldn't have done in an apartment), and my startup costs (closing costs and down payment) to see what kind of returns I've seen in my two years in the place. Here is a breakdown of what was included:

• closing costs (less than 1% of loan value)
  
• down payment (11% of home price)
• monthly payments (20 year 5/1 ARM with initial 5.o% rate, plus taxes and insurance)
• maintenance costs (only those that would not have been incurred in a rental)
• improvement costs (landscaping, new hardware, painting, etc.)
  
• Sale proceeds, assuming market value and a 6% realtor fee (which we won't be paying when we actually sell, but included for illustrative purposes)

The end result? We broke even, spending $100 more than we gained in the 2 years we have lived there. That may not sound good, but it is . . . and here's why. We lived in the house for those two years. That means we had no rent to pay. Between rent and renter's insurance, we had been paying about $820 per month to rent before we bought the house. (As an aside, this apartment was 500 sq ft smaller than our house and had no garage . . . so our living situation improved as well.)

When I factored in the monthly rental savings (assuming no increase in rent-- which is doubtful), I get a considerably different bottom line-- an internal rate of return of more than 44% annually. Forty-four percent. Now THAT is a return on investment.

The usual caveats apply-- your mileage may vary, your market may differ, etc. In fact, I'm certain that such a gain would not have been possible in larger markets because of the considerable cost difference between renting and owning. But in a market where they are relatively close, like mine, your returns from buying a home over renting can be tremendous. Ours certainly have been.

June Net Worth Update

Okay, so I'm on the 1st of the month now. I'll try to keep it here from now on, but it will certainly test my patience.

It was a good month (well, 3 weeks) overall. Net Worth is up 2.66% over last month, bringing me up to a 20.4% gain over February. I'm about 58% of the way toward my goal for the year. See the chart below.


Of the growth, about 32% comes from debt reduction, 20% from investment gains, and 48% from new savings/investments. I expect debt reduction to continue to be a big factor until my car loan goes away (either from downsizing my vehicle or paying it off). That will be December, at the latest. At that point debt reduction should be a smaller share of my growth each month and new savings and investments should take off.

As promised, I also calculated Net Investable Assets (5.01% gain) and Net Liquid Assets (14.19% gain). Both represent an increased share of my Net Worth, which I consider a very good thing. My equity in my home is going to keep rising but I want the more liquid assets to fuel most of the growth.

Things are going pretty well, at least partly do to the continuing rise of the stock market. But I'm young, so if we eventually have that pullback that everyone is calling for, it will be an opportunity to buy up cheaper shares. I've got plenty of time for it to catch back up.