Carnival of personal finance #106

My article on living on interest payments in retirement is featured in the Carnival of Personal Finance #106, now up at Digerati Life, which by the way is an excellent blog about finance and technology run by an immigrant engineer based in Silicon valley.

Here are some other articles from the carnival that interested me:

Early retirement planning: case studies

Found this excellent thread at about a 40-year old couple planning "semi-retirement" in 5-7 years and "full retirement" in 12 years. Their assets (net worth of about $1.5 M) and income ($240K-$260K) are well beyond ours, but I still found it very interesting.

Some notes:

  • They contribute an astounding 50% of their gross income to retirement and college saving accounts.
  • Their current asset allocation is 70% US equities, 15% International, 10% Bonds, 5% Cash. The suggestion from the group is to increase bond holdings gradually, leading to a 60/40 split of stocks/bonds at final retirement.
  • They use FIRECalc to do Monte Carlo simulations on their retirement withdrawals, I tool that I too have played with a bit.
  • For the semi-retirement period, they plan to allocate $10K/year for health insurance premiums. The response from the group is that this is on the low side.

Related posts:
Other early retirement case studies:

Roth IRA conversion during early retirement

Many people convert their Traditional IRAs to Roth IRAs due to the favorable tax treatment given to Roth IRAs. Under current law, money held in a Roth IRA is completely free from all future federal and state taxes. This is especially attractive if you believe that you will be in a high tax bracket during retirement, or if you expect the tax rates to go up in the future. You pay tax during the conversion process, in effect trading current tax payments for a reduction in future tax liability.

There is one group of people for whom Roth conversions are especially attractive -- early retirees who are living off the savings in their taxable accounts. This is especially true if you plan to retire abroad. Since your income is likely to be lower during early retirement years, it would be an ideal time to convert your Traditional IRAs to Roth IRAs. If planned properly, this can save a considerable amount in overall taxes.

What if your retirement savings are not in an IRA, but in another type of tax-deferred account like a 401(k) or a 403(b)? No problem -- these accounts can rolled over to a Traditional IRA using a direct rollover, and then converted to Roth.

What if your IRA was funded with non-deductible contributions? In this case, Roth conversion is even more attractive, since the portion of the converted amount that comes from nondeductible contributions is not taxed during the conversion. You will only be taxed on the earnings and on any deductible portion in your IRA.

Here are some more details about the Roth conversion process:

  • Although usually described as a "conversion", what really happens is a rollover. You are transferring money from one account to another account, usually held with the same custodian.
  • Currently, you may convert from a traditional IRA to a Roth IRA if your AGI (Adjusted Gross Income) is less than $100,000. The same limit applies to both single filers and married filers filing jointly.
  • Even the $100K income limit for converting to a Roth IRA will disappear in 2010, thanks to Tax Increase Prevention and Reconciliation Act (TIPRA) signed into law in May 2006. Unless the law is changed again, Roth conversions will then be available to all.
  • The 10% penalty for an early withdrawal from an IRA account does not apply to Roth conversions, so the conversion can be done at any age.
  • Taxes for Roth conversion are calculated by adding the converted amount to your AGI for the year in which the conversion was done, and then calculating your taxes using regular tax tables.
  • If you are living and working abroad when you do a Roth conversion, your income earned overseas will qualify for foreign earned income exclusion. For 2007, up to $82,400 can be excluded from AGI. However, due to changes introduced in TIPRA, your tax bracket may be higher than they used to be in previous years, so you need to be careful about attempting a Roth conversion.
  • The conversion can be spread out over several years (i.e., doing a partial conversion each year) so that you stay in a low enough tax bracket, taking into account your other taxable income for each year.
  • If you have multiple IRA accounts, you get to choose which ones to convert first (and whether to convert at all). For most people, the account with the most growth potential should be converted first. There are more aggressive strategies available for handling this decision, however.
  • Once the IRA has been converted, you will have to wait 5 years before the converted amount can be withdrawn penalty-free. Otherwise a 10% penalty will apply, unless you are over age 59.5.

For an extreme example, consider a retired couple living abroad with only $12,000 in taxable interest income in 2007, and taking the standard deduction.

They can deduct the standard deduction and personal exemptions from the AGI to calculate their taxable income. The 2007 standard deduction for a married couple filing jointly is $10,700 and personal exemptions are $3,400 each. So they will only owe tax on the amount by which their AGI exceeds $17,500 (= 10,700+3,400+3,400).

According to the 2007 tax schedule for a married couple filing jointly, they will be in the 10% federal bracket till their taxable income is $15,650, and in the $15% federal bracket till their taxable income is $63,700. This means that they can convert up to $5,500 (= 17,500-12,000) to a Roth IRA tax-free, another $15,650 at 10% tax rate, and up to $48,050 (=63,700-15,650) more at a 15% rate.

Related links:

Living on interest payments in retirement?

A common misconception about retirement planning is that once you have enough savings, you can "live on the interest payments" in retirement, without dipping into the principal.

For example, see the following comment by Ron Pearson, a financial planner who practices in Virginia Beach, Va., as quoted in Financial Planning magazine:

My biggest challenge is to help my clients understand the total return concept and how best to take an inflation-adjusted income stream. Many of them are still in the "spend interest, don't touch principal" mindset.

This shows that many people are not aware of the real impact of inflation over many years. I will use a simple example to illustrate this. Consider the case of someone with a $300,000 nest egg, who needs a $1000 monthly income to supplement income from other sources like pension or social security. (By the way, this also happens to be my income goal for "early retirement" as explained in an earlier post).

Let us assume that the savings are invested to give 5% investment return (close to the recent yield of 10-year treasury notes). If we go with the "spend interest, don't touch principal" strategy, and withdraw 5% every year, this would yield more than the required amount in the first year of retirement.

First, consider the case where the inflation rate is at 3%. The result will be as shown in the table below.For the first year, the monthly income is well over the $1000 target. By the 15th year however, the "real" monthly income (inflation-adjusted) has shrunk to a little over $800.

Next, consider what a 6% inflation rate can do.

By the 15th year, the income has decreased to almost half of the original target!

So, what is a better strategy? It consists of two things:

  • Start with a conservative withdrawal rate not related to the investment return rate. Most financial planners agree that this rate cannot be more than 4%.
  • Adjust the withdrawal rate in the following years so that the income remains fixed in inflation-adjusted terms.

Now let us revisit the two cases above, using the "4%-with-inflation-adjusted-increases" strategy.

First, with 3% inflation:

Next, with 6% inflation:

This strategy gives a fixed "real" income stream for many years. Exactly how long the money will last depends on the inflation rate, and your investment returns.

In the case of 6% inflation, note that the withdrawal rate has gone up to almost 11% by the 15th year. This is clearly not sustainable -- you will run out of money within a few more years. This is not a surprise, since you can't expect to survive for long on 5% investment return when inflation is at 6%.

In case you were curious, the withdrawal rate for a given year is calculated in terms of the withdrawal rate in the previous year using the following formula:

wn+1 = wn * (1 + f)/(1 + r - wn)
where wn is the withdrawal rate for year n, f is the inflation rate, and r is the investment return rate. In practice, both your investment returns and the inflation rate can fluctuate considerably during retirement, so this formula only provides a guideline.

Related links:

Book Review: In Spite of the Gods: The Strange Rise of Modern India

I just finished reading this book, published earlier this year, about contemporary India. It is written by Edward Luce, a British journalist who spent much time in India and appears to have a keen insight into the problems and potential of India.

I found it to be a fascinating read. I was amazed by the breadth and depth of the topics covered in the book. While it is a very readable introduction to the politics, culture and economy of modern India, it does not dumb down the subject for western readers as books of this sort sometimes do. It also gives a more realistic view of things compared to the portrayal in the Indian media where it is hard to tell the truth apart from the hype.

The book argues persuasively that a "triangular dance" between the United States, China and India will shape the twenty-first century economy. It is also blunt about the many serious obstacles that remain before India can be a true economic power. I recommend it for anyone interested in the current state of things in India.

Where did all the money go?

I posted our Net Worth chart for the last 10 years earlier.

When I generated this information from Quicken, I also ran a report on our income and expenses for the 10 years from 1997 to 2006. The results were quite interesting (at least for me), so I thought I will post that here as well.

This also explains the categories that I use in Quicken to itemize expenses. I never liked the default categories that came with Quicken, so I customized it till I had about a dozen categories that I really wanted to keep track of. Here they are, along with the percentage of our income over the last 10 years that went into each category:

  • Payroll taxes [24%]: Federal, state, Social security, Medicare
  • Housing [17%]: Rent, Mortgage, Property taxes, Homeowner insurance, Home improvement expenses (but not routine maintenance)
  • Merchandise [7%]: This includes all kind of "things" we buy. I used to track this in separate subcategories like books, clothes, electronics, furniture etc., but now I realize that every single item here must be sold, thrown out or given away at some point, so I just group them together.
  • Car expenses [6%]: Auto purchase costs, gas, service, auto and liability insurance, registration fees.
  • Entertainment [6%]: This is mainly vacations and dining out.
  • School and child care [4%]
  • Services [3%]: Memberships, subscriptions, Lawn care, Dry cleaning, Hair salon etc.
  • Groceries and Food [3%]: This is for groceries and other food-related expenses (but not eating out)
  • Utilities [3%]: Electricity, Gas, Phone, Cable, Internet
  • Medical and Dental expenses [2%]: Medical insurance premiums and out-of-pocket expenses. I also included disability and term life insurance payments here.
  • Gifts and charity [2%]: Charitable contributions and cash gifts (the latter mostly to family and relatives)
  • Savings [23%]: This is not a category, but is whatever is left after all expenses are subtracted from our income.
Some thoughts:
  • The amount of money we pay in payroll taxes never fails to amaze me. It is as if we worked for 2.4 years out of the last 10 just to pay taxes.
  • Overall, I am quite happy with our savings rate. Most of the savings went into our retirement accounts. We also paid for a small real estate investment out of our savings.

Switched to custom domain

I switched the blog to a custom domain today. It is still hosted at Blogger, but no longer uses the blogspot address. The new URL is

Any old links and bookmarks will continue to work, since Blogger forwards them to the new domain. I have to experiment a bit more to make sure that everything works right.