Month: April 2021

Travel Rewards Basics: Saving Money on Travel

Post author By Mr. MFI
Post date April 25, 2021

Photo by Andrea Piacquadio on Pexels.com

BLUF: Travels rewards are an effective way to greatly reduce the cost of traveling by minimizing or eliminating your airline and hotel costs. It lets you keep experiencing the world while not blowing your budget!

Who doesn’t love to travel? See different fascinating places, experience different cultures, visit different famous places and oh my, the food. The problem, is the cost of all that fun. Being that this is an FI focused blog, controlling expenses is important as that helps us reach our goal faster. I’m willing to spend the money on vacations, but I’m all for paying less for the same experiences. What’s not to like about that?

What are Travel Rewards?

Travel rewards, also referred to sometimes as either travel hacking or credit card hacking. The concept goes by a variety of different names but they generally mean the same thing. We’re trying to use credit cards to reduce or eliminate travel expenses. These usually revolves around the two largest expenses in a trip which are transportation (airline fares) and lodging (hotel costs).

How? You use normal life spending (groceries, gas, restaurants…etc) put on a rewards credit card to accumulate points. Those points can then be used to book airfare, hotels and rental cars outright or can be used to reduce the cost of them.

For example, say that a couple lived in Atlanta and wanted to take a trip to Hawaii. Atlanta is a hub for Delta so you look online. The cheapest option in late May would be $1,461.22 for two people. Most people would just chalk that up to the normal price of travel, pay and move in. Maybe they would charge it to a 2% cash back card and get $30 back for the purchase.

Example of a typical trip from Atlanta to Hawaii using cash.

Wouldn’t it be nice if you didn’t have to pay for that airfare? On the Delta website you can very easily flip from paying in cash to miles. Picking the exact same flights I see that it costs 70,000 miles and $22.40 to book using miles. Okay, now to get 70,000 miles.

Same trip from Atlanta to Hawaii using miles.

Right on Deltas website there’s a section for credit cards tied to SkyMiles which is Delta’s mileage program.

Boom! Right on the page there’s an American Express card that conveniently has a 70,000 mile bonus right now with no annual fee for the first year. The only stipulation is that you spend $2,000 in the first 3 months. Spending $670/mo should be problem for anyone with the life expenses that you can charge to a credit card.

Just like that we flew to Hawaii round trip spending $22.41 for two people instead of $1,461.

Types of Travel Rewards Programs

There are three main groups of travel rewards credit cards out there. Let’s dive into the details of each.

Flexible Points Programs

Flexible points programs give you rewards in points associated with their respective programs. Then, depending on the program you can either book travel directly with the company using their travel portal, transfer points to airline or hotel partners in their rewards point system or redeem the points for cash. The best deals are usually via points transfers but your mileage may vary (pun intended 😃).

One great thing about these programs is that the points usually don’t expire. As long as you maintain an account in good standing with them (at least one card) then they just sit there.

Chase Ultimate Rewards (UR) Points – This is one of the most popular programs due to the high value of their points, large number of card options and large number of transfer partners. You can buy travel directly through their website, transfer points to travel partners in their rewards programs or take the points as cash.
American Express Membership Rewards (MR) Points – Also very popular and some people prefer it over Chase. It has different transfer partners than Chase. You can buy travel directly through their website, transfer points to travel partners in their rewards programs or take the points as cash.
Citibank ThankYou Points – A newer player to the flexible points programs game these aren’t as publicized but they work in a similar way. Just like Chase and American Express they let you book travel directly through a portal with them, transfer them to partners or redeem them for cash.
Capital One “Miles” – Capital One calls its system miles but it’s really a flexible points system like the others. In general it’s the least valuable because it has the fewest transfer partners, which is where you get the most value from your miles. It does have one unique feature in that you can use your miles to wipe out any travel expense that you pay for in cash at $0.01 per mile. For example, you could use 50,000 “miles” to wipe out a $500 rental car charge on your Capital One card. This is one way to get reimbursed for other travel expenses that you otherwise might have trouble getting for free.

Note that while these programs are very flexible, they don’t transfer to ALL airlines and hotels out there. For example, Chase UR points don’t transfer directly to Delta at the time of writing this article (see image below). You can use the points to book Delta through their portal. American Express DOES transfer to Delta. It’s best to go into accumulating points in these programs with a next trip in mind so that your spending gets you points that you know you will use.

Chase UR Airline Partners in April 2021

Airline Miles Programs

Each airline has their own mileage programs and they partner with different credit card companies to offer credit cards that accumulate miles in those awards programs. Spending money with those cards accumulates miles and the sign up bonus (SUB) is also paid out in those miles.

For example, here are a couple different Chase cards associated with different airlines. The United card would give you Explorer miles and the British Airways card would give you Avios points. When you open these cards they connect with an existing rewards account with the airline or open a new one if you didn’t already have one.

Your points are automatically transferred over to the airline account (often monthly) so your points are safe even if you cancel the credit card. Each airline has it’s own rules for points expiration though so be sure to look that up so your points don’t accidentally expire on you.

Hotel Points Programs

Hotel rewards cards work in the same way as airline cards. The biggest difference is that the value of each point can vary much more wildly between programs compared with the airlines.

Sub-optimal way to accumulate travel rewards

If I were to describe the perfect customer in the eyes of a credit card
company it would probably go something like this. A customer is lured into signing up for a card with a substantial SUB, but doesn’t hit the minimum spend to get the bonus. They keep the card their whole life and carry an account balance the entire time.

I know my readers are smarter than that and would never do those things. However, many customers do get a SUB and then just keep a credit card forever. They enjoyed that bonus and built loyalty over the year they have it and often keep the card. That’s exactly what the credit card companies are hoping you do.

What’s the problem with that? It will take you forever to accumulate travel rewards after the SUB. In the previous Delta example we spent $2,000 in 3 months and flew to Hawaii for free. After that though, you accumulate 2x miles on dining and 2x miles on groceries. If I spend $800/month on groceries and $200/month on dining that’s $12,000 or 24,000 miles a year. It would take me 3 years to earn enough miles to go back to Hawaii! 3 months vs. 3 years. That’s the power of the SUB!

Supercharged travel rewards

What’s the optimal way to accumulate travel rewards then? Maximize the SUB of course. Open a credit card, spend enough to hit the SUB and then move on to another card. How effective is this? Very. In the last 18 months my Mrs. MFI and I have 308,000 UR points, 115,000 United miles and 61,000 American Airline miles. This is all using personal spending in a household of two people that spends less than $60k a year.

…But it will destroy my credit!

One of the most common misconceptions is that travel rewards (also sometimes card credit card churning) will destroy your credit score. Surely opening and closing that many accounts must hurt your score? Nope. This might be obvious to you if you read my article on how credit scores work and how to increase yours.

Yes, you take a small temporary hit when accounts are opened but the number of open accounts is a low contributor to your credit score. Payment history and credit utilization are high contributors to your credit score and both are improved with more cards open. Obviously this assumes on time payments and not carrying a balance. Opening 4 personal credit cards in the last 18 months still has my scores in the 800s.

My credit scores are doing just fine…

People that should and should NOT try travel rewards:

Just like casino’s being built on the money from the losing gamblers, credit card companies profit from the people that aren’t responsible with their credit. The people that use travel rewards successfully are losing credit card companies money but those people are the minority of credit users. If you are going to truly use travel rewards to save money then you MUST be a responsible credit card user.

People that should try travel rewards:

Have good credit scores of at least 700. All the best rewards cards require excellent credit.
Pay off their credit cards in full each month (they never pay interest charges).
Know how to control their spending and can hit the minimum.

Travel Rewards Essential Tips:

Plan our your trips far in advance. It takes time to open cards, hit the spend limits and get awarded mileage. Also, the best deals get booked up early so you can’t usually get good points deals last minute unless demand is low.
Target cards and points to a trip, not just randomly based on the best SUB. It’s alluring to stockpile points but what good is that if you have trouble using them? Best to pick a trip then focus on how to get airfare and hotels on that trip for free.
Never sign up for a card until you have a plan to hit the SUB spending requirement using your normal life expenses. If you’re spending money that you otherwise wouldn’t to hit a SUB, are you really saving money? This sometimes means opening cards around major purchases or expensive yearly costs like insurance premiums and taxes.
Don’t sign up for a new card within a month of the last card. This can be a red flag and could get you denied.
Play the game with two players. If you have a spouse, have both people sign up for cards. This allows you to do cool things like sign up for a card and then refer your partner getting you each a bonus.
Keep all cards open for at least a year and never cancel right after hitting the SUB. This can trigger that you’re abusing the system and set off red flags. When you’ve had a card for a year the annual fee will hit again. At this point you can close the card and they will credit back the annual fee.

Action Steps:

Figure out the next trip that you want to take that requires flying.
See what it would cost you to take that trip paying for it with cash. Then see how many miles it would take you to book the same trip.
Look at the airline credit cards available and see if there’s a card that can get you the points that you need. This might be only one card or could require two different cards. Besides airlines there are lots of sites like Nerdwallet and The Points Guy with up to date info on the cards with the best rewards.
Sign up, hit the minimum spend, get the SUB and book those flights for free!

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Tags Credit Card Hacking, Travel, Travel Hacking, Travel Rewards

Taxes

401k vs Brokerage Account: Which Wins when Income Taxes Rise?

Post author By Mr. MFI
Post date April 18, 2021

Photo by Pixabay on Pexels.com

BLUF: Income taxes will most likely rise in the future but 401k pre-tax investing net of taxes in this scenario still lasts longer than a brokerage account. Withdrawal needs in retirement would need to be high and taxation at or exceeding historical highs in the future for a brokerage account to catch up to a 401k.

Why I wrote this article

Pre-tax investing has always sounds like a great idea to me. I get to avoid paying paying Uncle Sam taxes from a high tax bracket now, let the money grow tax free and then pay income taxes from lower brackets in the future (because you will be drawing less from those accounts).

Then I listened to a podcast. I listened to an Afford Anything podcast with this guy Ed Slott who published a new book “The New Retirement Savings Timebomb.” Sounds big and scary, right? Well, Ed sure sold it that way. His premise is that tax rates are historically low now and are sure to go up in the future. Additionally, the (marginal) tax rates in the past have been as high as 90%. The horror! As such his advice was that young people should be putting 100% of their money into a Roth, NOT be doing any pre-tax investing.

That made my ears perk up. Anytime I hear personal finance advice that flies contrary to what I had thought I like to investigate it. This all sounded eerily like a scare tactic to sell his book but because I honestly never did the math of which accounts perform better with taxes factored in, I couldn’t be sure. In this post we’ll follow the hypothetical lives of two married couples to see how the Traditional 401k vs. Brokerage / Roth 401k could play out over a lifetime. Note that this entire post will use a married filing jointly example but the principles still apply to those in other filing situations.

Let’s talk taxes

This discussion requires a solid foundation in how the US tax system works so lets make sure that everyone is on the same page there. I know, talking taxes sounds about as exciting as going to the dentist. I’ll keep it brief!

How a progressive tax system works

In the United States we have a progressive tax system. The income that you earn starts out being taxed at a low rate and the taxation increases as you make more money. Each chunk of income that is taxed at a different rate is referred to as a tax bracket. $0 to $19,900 is a bracket of income that is taxed at the 10% rate in 2021 for married couples filing their taxes jointly. The next dollars you earn from $19,901 to $81,050 are taxed at 12% and so on.

These tax brackets are indexed to inflation from a law passed in 1984 meaning that the dollar amounts typically go up every year.

How taxes are calculated

The most common mistake people make is thinking that the highest tax bracket that their money “touches” is the rate that ALL their money is taxed at. For example, if a couple makes $200,000 they think that their taxation is $200,000 * 24% = $48,000 which is wrong. This leads people to try and do silly things just to stay out of the next highest tax bracket when it doesn’t make much of a difference.

The table below shows how your taxes are actually calculated. If a couple makes $200,000 a year, the first thing that comes off the top is their $25,100 standard deduction. This is free income that is untaxed leaving the couple with $174,900 that is subject to taxation. Each bracket of income is then taxed at each tax rate and added up to a total tax. As you can see only the income above $172,750 is taxed at 24%. $2,150*24% = $516.

Tax calculation example for a 2021 married couple filing jointly

Take all those individual tax bracket amounts and sum them up and you get the total taxes that you owe. In this case $30,017 on an income of $200,000.

Marginal Tax Rate vs. Effective Tax Rate

The highest tax bracket that your money touches is called your marginal tax rate. In the previous example for a couple making $200k, that’s 24%. Since that is the marginal tax rate is thrown around sometimes people freak out and mentally use that number to calculate what they think they’re going to own.

In reality, what you actually owe in the end and what you should care about is your effective tax rate. This is the percentage of tax that you actually paid on the taxable income that you earned.

For example, this couple ended up owing $30,017 on an income of $200,000. $30,017/$200,000 = 15% effective tax rate. Sounds a lot better than 24%, doesn’t it? The problem is that marginal tax rates to figure out by glancing at a table while you need to calculate your effective tax rate taking a number of things about your tax situation into account. For that reason the marginal tax rate number will often be used in discussion. Now that you know what it means don’t let that trip you up!

Taxes in the future

We do need to recognize that income taxes around 2020 are quite low. If no laws change, on January 1st, 2026 taxes brackets will reset from the Tax Cuts and Jobs Act (TCJA) of 2017 expiring with the following changes:

12% tax rate goes back up to 15%
22% tax rate goes back up to 25%
24% tax rate goes back up to 28%^[2]

Outside of that there is speculation that taxation increase will be required to pay for the massive money printing to recover from the pandemic. Going back to Ed Slotts’ comments when he said taxes have been as high as 90+%. He’s not wrong, but the comment is misleading and scary for the average person. In 1944 at the tail end of WW2, taxes for the highest (marginal) tax bracket were 94%!^[3] What he doesn’t mention is that it was for income exceeding $3 million in 2021 dollars. Allow me to get out my tiny violin for you if you’re crushing the game like that. The lowest bracket was 23% (still high) on up to ~$30k in 2021 dollars.^[3]

Investment Account Taxation

To make sure that we’re on the same page with how taxation works with retirement and brokerage accounts lets review the topic.

Pre-Tax Accounts: 401k Investment Taxation

Using a 401k investment account means the money comes out of your paycheck tax free and reduces your taxable income. When you reach 59.5 years of age and withdraw the money it’s taxed as ordinary income just like a W2 paycheck today. Until you withdraw that money it’s allowed to grow tax free inside the 401k account. The near term benefit is that you save that money AND it reduces your tax bill.

The argument Ed Slott makes is that income taxes now are pretty low and they’ll be much higher in the future. You should pay those taxes today and put the money into a Roth 401k post-tax.

Post-Tax Accounts: Brokerage account & Roth 401k Investment Taxation

In this example I’m using a brokerage account because it’s accessible to many and allows you to contribute at least as much as the traditional 401k so we can compare apples to apples.

Brokerage Account:

A brokerage account is not a retirement account. Anyone can open one and the money simply goes in after all normal payroll taxes have been removed. You can then buy stocks, bonds and other alternative assets with those funds. If you sell assets within a year of buying them they’re called short term capital gains and are taxed as ordinary income. If you hold them for longer than a year then they’re taxed at a special, lower rate.

The 0% tax bracket is large enough that many couples in retirement can sell long term gains and pay no taxes. Unqualified dividends and bond interest is taxed differently but using your standard deduction that can be wiped away. The example below shows how a couple could withdraw $100,000 from a brokerage account in a year and pay $0 in tax.

Roth 401k:

Contributions to a Roth 401k have ordinary income taxes taken out of it first and then the money goes in after tax. The advantage is that when you withdraw the money there’s no tax to pay!

Case Study: 401k Fanatics vs. The Brokerage Buyers (or Roth 401k)

To see how a lifetime of saving, investing, withdrawals and taxation happens in an apples to apples comparison I give you the following scenario.

Overview

To make this fair they both have the same exact gross income and very high expenses (they aren’t good savers) every year. The 401k Fanatics max out their pre-tax 401k at $39k/yr and then are left with $0. The Brokerage Buyers followed Ed Slotts advice and paid the taxes first and contributed everything to a post-tax account. Because of that they are taxed more heavily on their income and have a smaller amount of post tax dollars to put into their brokerage account per year – $30,378.

401k Fanatics:

Below is what a typical year looks like for the 401k Fanatics.

Brokerage Buyers:

Below is what a typical year looks like for the Brokerage Buyers. With no pre-tax contributions they pay more in taxes up front and therefore have less money to invest in their brokerage account each year ($30,378) compared with the $39k/yr of the 401k Fanatics.

Assumptions:

Tax brackets – both couples incomes are taxed at 2021 tax levels through the accumulation phase. In the withdrawal phase we’ll vary the tax rates to see what happens.
Investments – both couples invest in the same low cost VTSAX index funds monthly. $3,250/mo for the 401k fanatics ($39,000/12) and $2,531.50/mo for the Brokerage Buyers ($30,378/12).
Investment returns – both couples get 7% average annual returns compounded monthly.
Brokerage account taxes – since income needs of the Brokerage Buyer couple are within the 2021 capital gains 0% bracket it is assumed that they pay no taxes upon withdrawal. For this reason the brokerage account is interchangeable with a Roth 401k for tax reasons in this example. They all pay $0 in tax when withdrawing. Any dividend or bond income is expected to be small enough to fall within the standard deduction.
Inflation – we’re going to use 2021 dollars all the way though the example. Expenses will rise with inflation but it is assumed to impact both couples the same.

15 Years of Saving and Investing Later…

How have our good little saving and investing couples done? Quite well! They started later in life at 45 years old and are now 60 after saving for 15 years. The 401k Fanatics are millionaires in the two comma club while the Brokerage Buyers have accumulated a healthy $807k in their brokerage account.

Retirement time! Who wins?

After 15 years of investing the couples have retired. They’ve paid off their house and cars and now only need $80k/yr to support their lifestyle. Let’s see what happens when the 401k Fanatics have to pay ordinary income tax on those withdrawals while the Brokerage Buyers get to laugh in the face of the tax man all the way to the bank!

Income taxes rise to 2026 levels

What happens if congress does nothing, the tax rates reset higher and that continues into the future? See below for the 2026 tax rate impact on our 401k Fanatics.

Hey now, what happened? The 401k Fanatics were able to make that money last almost 7 years longer than the Brokerage Buyers despite them paying 0% tax. Why? Well with the progressive tax brackets the 401k Fanatics are still only paying a 9.62% effective tax rate. Projected far into the future the Brokerage Buyers will still never catch them.

Income taxes rise to scary “2036” levels

Okay, maybe you believe that taxes will get much higher. After all, the fed has been printing money faster than Leonardo DiCaprio in Catch me if you can. I’m calling them “2036” tax brackets. What then?

The lowest rate becomes 15%, then 20% and increasing up to 70%! Yikes! That would be pretty bad.

Surely that must have tipped the scaled in favor of the Brokerage Buyers paying 0% tax? Well, nope. The 401k Fanatics effective tax rate went up to 13.5% and still get 4 more years of money than the Brokerage Buyers. Even projected far into the future they would never catch them.

The obvious next question that I had to answer was how bad would future tax rates have to get for these two couples to run out of money at the same time? Well pretty horrifically bad – I believe the worst in history even topping 1944 WW2 levels when the first bracket, $0 – $30k (inflation adjusted) was 23%!^[3] I had to come up with a 22.11% effective tax rate to make then break even.

What does that look like for tax brackets? I played with some numbers to come up with one potential. I thought that the “Doomsday” naming was appropriate.

Conclusions:

The big takeaway from this for me is that you really need to focus on effective tax rates when thinking about taxes in the future. Pre-tax money will always grow faster initially by comparison because you can simply save more of it. If you have really poor 401k investment options with high expense ratios that would certainly narrow the gap over but it’s situation dependent on how close the outcome would be.

The other observation is that the more you need to consume, the more of a tax penalty you pay and the more you need to worry about tax rates. I can’t imagine a world where the rich and poor pay a flat tax so the lower incomes will likely be taxed less. The less you can live on, the less you’ll be taxed.

Early Retirement Considerations:

Winning is great, but you don’t win if you can’t retire early because you can’t access the money. If you have an early retirement plan you do need to balance 401k investing with post-tax investing because having more money in a 401k doesn’t matter if you can’t access it when you need it.

Most people saving 50+% of their income can max out a 401k and contribute a substantial amount to a Roth and a brokerage account. That said, everyone’s situation is different and you need to plan out your investments to have the money you need, in the right buckets, at the right time.

Action Steps:

Make sure you are investing in a 401k to get your employer match. That’s a 100% ROI!
If you’re just starting out consider trying to maximize those pre-tax buckets.
After that consider Roth IRA contributions.
Build that brokerage account. Have you considered putting some of your emergency fund in there?
If you plan to retire early, take a look at the different buckets of money. How much do you need to get to 60 years old to access retirement accounts? A detailed post coming on this topic.

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Sources

TaxPolicyCenter.Org. https://www.taxpolicycenter.org/statistics/historical-average-federal-tax-rates-all-households. Accessed 4/17/2021.
FedTaxPlanners.com. How 2026 Sunset Laws will impact your tax cuts. https://fedtaxplanners.com/how-2026-sunset-laws-impact-your-tax-cuts/ Accessed 4/17/2021.
Tax Foundation Tax Rate History. https://files.taxfoundation.org/legacy/docs/fed_individual_rate_history_nominal.pdf. Accessed 4/17/2021.

Tags 401k, Brokerage, Income taxes, taxes

General FI Investing

Should You Use Extra Money to Prepay Your Mortgage or Invest?

Post author By Mr. MFI
Post date April 11, 2021

BLUF: The decision to prepay your mortgage or invest will end up varying based on each individuals mortgage parameters, risk tolerance and goals. 2-4% mortgage rates make stock investing a better historical performer than prepaying your mortgage. However, you need to run the numbers AND consider other intangible benefits to arrive at what’s best for you.

Prepay Mortgage or Invest: A Common Quandary

I see this question posed all over personal finance forums and social media platforms. How the question is phrased depends on the person but usually goes something like this: “My mortgage is less than 4% and the market historically returns 7-8% on average. Isn’t it better to invest instead of pre-paying my mortgage?”

Alternatively, I’ll sometimes see hardcore investors bashing those that are paying off their mortgage early because they’re “making a poor choice” or are “leaving money on the table.” The conversation revolves around borrowed money being cheap and those long term investments outperforming the mortgage on average.

It’s very normal to want to want to make the “best” decision and I realized that I had never seriously considered this question in my situation. I always do the math as a part of my decision making process so this article will show my numbers, my process for evaluating the options and give you my thoughts on other considerations if you are faced with this decision.

Our situation:

Mrs. MFI and I have a cute little 1,500 sq/ft split level house here in NY (image above) that only cost me around $130k to buy near the peak of the housing boom. With a low purchase price, a refinance in the middle after my divorce and some overpayments along the way we only have $45,529 left to pay on my 30 year mortgage at 3.625% Before you hate us for that mortgage only costing $456 a month, consider that our property and school taxes are more than $456/mo. Sigh, thanks NY – the tax state.

Aside from my mortgage we’re debt free! Having crushed my old debts and consumer ways there is a part of me that would love to pay off the mortgage and have no debts. However, we’re also saving hard to reach financial independence and that includes after tax savings in a brokerage account as we’ve used our tax advantaged options. As such, we have about $1,000 a month that could either be used to make additional principle only mortgage payments, invest in our brokerage account or some blend of the two. What should we do?

The Comparison Approach:

If the 30 year mortgage is taken to term with no additional payments it will be paid off in March 2031, just under 10 years from today. With that being the baseline case of do nothing extra and stay the course I came up with a variety of options that I could do between now and 3/1/2031 which is the end of the time period for the study.

Comparison options:

Option #1 – Pay the normal mortgage payment ($456). Invest $1,000/mo into a brokerage account until the end of the study (3/1/2031).
Option #2 – Pay the normal mortgage payment ($456) plus a $250/mo principle only payment. Invest $750/mo in a brokerage until the mortgage is paid off (4/1/2027). At that point invest the full $1456 ($456+$250+$750) into the brokerage until the end of the study (3/1/2031).
Option #3 – Pay the normal mortgage payment ($456) plus a $500/mo principle only payment. Invest $500/mo in a brokerage until the mortgage is paid off (8/1/2025). At that point invest the full $1456 ($456+$500+$500) into the brokerage until the end of the study (3/1/2031).
Option #4 – Pay the normal mortgage payment ($456) plus a $1,000/mo principle only payment. Invest $0/mo in a brokerage until the mortgage is paid off (1/1/2024). At that point invest the full $1456 ($456+$1,000) into the brokerage until the end of the study (3/1/2031).

The comparison data in tabular form.

In all of these cases I have the $456 monthly mortgage payment and $1,000 extra to use to either pre-pay the mortgage or invest in stock based index funds in a brokerage account. In cases where the mortgage pays off earlier than 3/1/2031 (the end of the study) I apply the extra money to the investment account.

The great unknown in all of this is the investment return of the stock market over the next 10 years. I took three different average returns over the 10 year period and used that to calculate the brokerage returns. The four values used were -3.8% (worst 10 year period in S&P history since 1928^[1]), 0% (a lost decade), 7% (long range historical average), 13% (a continued raging bull market).

Resultant Data:

What information did I want at the end to help with my decision of which option was better? There were a few things:

Mortgage Payoff Date – I wanted to see where in time this would fall so I could see if I might be at FI before the mortgage was gone.
Mortgage Net Worth Change – This would be important if we were calculating a timeframe where the mortgage wouldn’t be payed off such as 5 years. In my case, all cases pay off the mortgage so it’s $45,529 for each.
Brokerage Account Net Worth Change – How much would that brokerage account balance change for each method? The account is already in use so I’m looking at the change in value not the absolute value.

The Process:

How did I do this? I use two main spreadsheets. First I used a loan amortization schedule spreadsheet (widely available for free on the internet) that let me include monthly principle only payment amounts. I made a sheet for each option. That sheet provided me with certain pieces of information that I cared about including number of remaining payments, remaining interest paid for each option and the date of the mortgage payoff. Well, it at least gave me the data to calculate remaining payments and interest paid.

The second spreadsheet I used is a compound interest sheet that included an option for regular deposits. I created one of these sheets for each option and varied the investment timeline. I had to take the mortgage payoff date calculated from the amortization spreadsheet to then input into this sheet the right time for the investment per month to flip to the full $1456.

The Results:

I’m honestly surprised by the results. What surprised me the most was that there really wasn’t a massive financial difference to the brokerage account balance between any of the options due to my small mortgage remaining and my short time horizon studied.

My small mortgage balance and 3.625% APR only results in a $6,372 difference in interest paid between option #1 and option #4. The biggest delta was between option #1 and option #2 dropping by $3,555.

Take the “average” 7% market return situation. There’s a $9,500 difference over a 10 year period between the extremes of option #1 and option #4 or $950 a year. Not exactly an amount of money that would keep me up at night with a fear of missing out (FOMO).

Option #1 puts the most into the brokerage account so it’s most susceptible to market gains (and losses) based on average annual return variation. Pre-paying a mortgage is locking in a guaranteed return on your money at a rate equal to your mortgage interest rate. For that reason option #4 fluctuates the least with returns.

The easy way to think about this is that if the average annual return of the stock market is greater than your mortgage APR then investing more will always result in a financially better outcome over mortgage pre-payment.

The surprising thing that I learned in calculating the numbers and thinking through this is that mortgage interest doesn’t really matter. In my case no matter what I’ll spend $1,456 a month. What matters if I want the best financial outcome is what makes my net worth grow the most over time for that $1,456. That means house value – mortgage remaining + change investing account balance over the investing timeframe. In my case all options decreased my mortgage by the full loan amount remaining of $45,529 so I didn’t show it.

A typical loan amortization calculator will show the interest paid.

Loan amortization calculators can lead you to focus on this as well showing you large interest numbers over the life of a loan. It’s easy to add a $500 extra payments and see that interest drop dramatically. What you don’t see is what your brokerage account value would do over time if you chose to invest that $500 for comparison.

My Decision:

Drum roll…I’m going to pursue option #2. This option keeps my brokerage contributions high while accelerating my mortgage payoff by 4 years. While it’s not important to have this house paid off by FI I am interested in the psychological impact and would like to accelerate that some.

The $4,250 brokerage account difference between option #1 & #2 is trivial to me so it’s a good balance between investing and accelerated paydown. Coincidentally, 80/20 (stock/bond) allocation is our investment plan so option #2 is very similar. Option #2 is $750 (stock) / $250 (mortgage) and mortgage pre-payment is almost bond like with a 3.625% return on my loan.

Things to Consider for Your Decision:

We all have our own unique situations to consider so my decision might not be the right one for you. Here are some things to keep in mind when contemplating this decision for you.

If your mortgage APR is less than 7% and you have a 20+ year investing time horizon then investing in the S&P500 has historically always done better, on average, than prepaying your mortgage. The S&P500 returned 7.3% on average over all 20 year periods from 1928 to 2018^[1].If the market returns 7% on average and your mortgage APR is 3% then you’ll make 4% more on average, compounding, over your investing life on any money that you invest in the S&P500 index instead of pre-paying your mortgage. Is it possible for the market to underperform your 3% mortgage over 20 years? Absolutely. But on average it won’t and since none of us has a crystal ball that’s the best that we’ve got.
Try not to fixate on mortgage interest saved when projecting what prepaying a mortgage will do for you financially. Look at overall net worth and factor in how your money would grow if you invested the money instead of paying down the mortgage.
Keep your big picture goals in mind. Eliminating a mortgage payment will drop your monthly expenses so it’s advantageous to have that happen before FI / retirement if you plan on staying in the house. It will influence your FI date so see when you want that mortgage gone and the impact of the reduced expenses on your FI number.
There’s a freeing feeling to being mortgage free (or so I’m told). Remember how good it felt when you paid off your car loans or when you were free of credit card debt? It’s hard to put a price on the feeling of not having a debt hanging over your head. Or the pride felt in knowing you own that house outright.
Pre-paying your mortgage is choosing a guaranteed return on your money of your mortgage APR assuming your house value is stable. If you are more conservative when it comes to risk tolerance then mortgage pre-payment will likely be a more attractive option.
You don’t have to choose the mathematically superior (most rational) choice that nets you the most money in the end. There are many reasonable choices on the spectrum between invest everything and don’t prepay any mortgage and invest nothing while aggressively paying off the mortgage.
It’s much harder to get at wealth that’s tied up in your mortgage. You can refinance it out or take out a HELOC but there are costs involved. If it’s sitting in your brokerage account it can serve as an emergency fund and is far more liquid.

Action Steps:

Make sure you understand your mortgage APR. How does that compare with 7%?
Download a mortgage amortization calculator and compare a mortgage prepay option to an investment option. Consider in between options like invest half and prepay half.
Make a decision and implement it into your budget.
Automate the investments and pre-payments to make it easy to stick with your plan.

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Have you done this analysis before? What did you choose and why? Comment below!

Sources:

FourPillarFreedom.com. Here’s How the S&P 500 Has Performed Since 1928. https://fourpillarfreedom.com/heres-how-the-sp-500-has-performed-since-1928/. Accessed 4/11/2021.
FreddieMac.com. 30-Year Fixed-Rate Mortgages Since 1971. http://www.freddiemac.com/pmms/pmms30.html. Accessed 4/11/2021.

Tags invest, mortgage, prepay mortgage

General FI

The 4% Rule: Do You Really Understand It?

Post author By Mr. MFI
Post date April 4, 2021

Photo by Karolina Grabowska on Pexels.com

BLUF: The 4% rule is a great starting point to establishing a financial target for early retirement in the beginning of your FI journey. However, it’s a rule of thumb, not a rule. It’s important to understand the details behind the 4% “rule” so you can factor in your individual factors such as taxes, fees, inflation and capital preservation. There’s also a much more complex subject of sequence of returns risk to explore.

Note: For copywrite reasons I can’t duplicate the tables of data from the Trinity study in this article. To get the most out of the article I recommend opening up the study to refer to the tables. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable” by Cooley, Hubbard and Walz.

If you’ve spent any amount of time around retirement, early retirement or financial independence forums you’ve no doubt encountered the term 4% rule thrown around repeatedly. In this article we’ll explore the academic study nicknamed the “Trinity Study” that gave birth to the concept, what the concept is and some considerations when applying it to your own financial independence plans. We’ll also introduce and discuss some terms that might be new to you such as a withdrawal rate (WR).

4% Rule and the Trinity study

The 4% rule is a principle that was created from the results of an academic study published in 1998 by three professors of finance at Trinity University. The paper is called “Retirement Savings: Choosing a Withdrawal Rate That is Sustainable” by Phillip L. Cooley, Carl M. Hubbard and Daniel T. Walz.^[1] This paper has been referred to as the Trinity study probably because it’s a whole lot easier to say so I’ll refer to the paper using that name going forward.

The Trinity study sought to answer the question: “What’s a reasonable withdrawal rate when living off savings?”^[1] A withdrawal rate (WR) is the percentage of your portfolio that you will withdraw in order to live. For example, if your portfolio was $1M when you retired and you withdraw 4% that first year then you take out $1,000,000 * 0.04 = $40,000.

The paper wanted to address a very real world dilemma that we all will hopefully face one day. “The dilemma is that if they withdraw too much, they prematurely exhaust the portfolio, but if they withdraw too little, they unnecessarily lower their standard of living.”^[1] The paper does not address early retirement though. It examined payout periods of 15-30 years since those would be much more typical of a standard retirement around age 65. More on that point later.

The Trinity study methods used:

The Trinity study used real annual returns from the S&P500 index for stocks and long term corporate bonds for any bond allocations. The study looked at different payout period lengths of 15, 20, 25 and 30 years using data between 1926 and 1995. Within those payout periods they tried different WR from 3% up to 12% and using 5 different asset allocations from 100% stocks to 100% bonds (100/0, 75/25, 50/50, 25/75, 0/100).

Here is an example of how they generated the data in Table 1 of the study which shows portfolio success rates. This would be a single data point of a 15 year payout period of 100% stocks at a 4% WR starting at 1926. A portfolio starts with a set value ($1,000 in this case) which doesn’t matter because everything is calculated relative to it. A 4% WR means that you assume you always take out 4% of the initial portfolio value ($1,000) or $40/year.

Each year you take the starting value, add in the annual return (or loss), subtract the money withdrawn and you end up with a final portfolio value. For example at the start: $1,000 + $80 (8% return) – $40 (4% withdrawn) = $1,040 at the end of 1926. This repeats for each year in the 15 year window. If you end up with any money at the end, in this case $161, then the portfolio is a success. Even $1 left means success in this study! Then you do this again starting in 1927, 1928 until you run out of data in 1995. That means the 15 year payout period has 56 different payout periods.

Study Results:

Photo by Alexander Suhorucov on Pexels.com

The tables are what people focus on in the study so here’s a summary of what you’re really looking at:

Trinity Study Table 1 – Portfolio success rates from 1926-1995. No inflation adjustment on withdrawals.
Trinity Study Table 2 – Portfolio success rates from 1946-1995. No inflation adjustment on withdrawals.
Trinity Study Table 3 – Portfolio success rates from 1926-1995. CPI inflation adjustment on withdrawals.
Trinity Study Table 4 – Terminal portfolio value from 1926-1995. No inflation adjustment on withdrawals.

Table #1 – Portfolio success rates (1926-1995)

The 3% WR as a fixed percentage of the initial portfolio value has a 100% chance of success for all payout periods, all asset mixes. Change that to a 4% WR and for 30 year retirements the chance of success is 100% for all asset allocations except 100% stocks (98% success). Again, success only means having greater than $0 left at the end of the payout period.

Table #2 – Portfolio success rates (1946-1995)

What happens when you take the same data set and ignore the time period of great depression and world war 2? A booming stock market and higher success rates. 100% success was guaranteed for a WR up to and including 7% for 30 years as long as you held at least 50% stocks.

Table #3 – Inflation Adjusted Portfolio success rates (1926-1995)

Take table 1 and sprinkle in inflation equivalent to the consumer price index (CPI) and you get table #3. What that means is that the WR starts at a percentage of the initial portfolio value $40 on $1,000 (4%) but then the amount you withdraw each year increases with inflation. The table below repeats the same scenario as earlier in the article but adds 3% inflation to each yearly withdrawal. The earlier scenario was successful with 16% of initial capital remaining ($161/$1,000) at the end but the inflation adjusted scenario fails in the last year (-$3).

Table 3 in the study shows high success rates for the 4% WR for 50% or more stocks but the higher bond portfolios get much worse at 25 and 30 year payout periods. Essentially all the probabilities get worse as inflation eats into the lower bond gains but at 3-4% WR the result is still excellent.

Inflation added to the withdrawals make a difference.

Table #4 – Terminal Value of a $1,000 Initial Portfolio After All Annual Withdrawals (no inflation) (1926-1995)

Table 4 takes the data from table 1 but instead of reporting the probability of portfolio success in each scenario it reports how much the portfolio will be worth at the end on average, minimum, maximum and median. It assumes you start with a $1,000 portfolio and take it to the end of the payout period for each block of time from 1926 to 1995.

Of all the table #4 data points I think the one in the lower left is the most interesting because it represents the longest time horizon and a “typical” early retiree asset allocation: 30 year payout period, 4% withdrawal rate, 75% stocks 25% bonds:

Average outcome: $9,031 (9x) the starting portfolio value
Worst outcome: $1,497 (1.5x) the starting portfolio value
Median outcome: $8,515 (8.5x) the starting portfolio value
Best outcome: $16,893 (16.9x) the starting portfolio value

This table on the surface would make you believe that with a 4% WR your money will always grow beyond your wildest dreams. On average, your portfolio increases by 9x the starting amount over 30 years with a 4% WR. Case closed right? Well, not so fast. That sneaky inflation thing is missing and not considering it is ignoring two areas that matter in the real world.

Inflation makes your expenses increase so withdrawals increase. The study ignores this fact but year after year our costs generally go up. As I show in the table below, you see the 1927 withdrawal becomes $41.2 instead of just $40 when you add inflation. Then it keeps compounding until you’re withdrawing $60.50 by 1940. Your costs, and therefore withdrawal amounts went up 50% in 15 years with 3% annual inflation. Inflation can vary greatly over time but form 1926 to 1995 it was 3.15% on average mostly driven by the later years.

Table 4 doesn’t tell you how inflation impacted the spending power of those terminal portfolio values. A lot can change in your spending power in 30 years.

For example, take the worst case outcome of $1,497 for 30 year, 75% stock example at a 4% WR. That’s 1.5x your money over 30 years. However, adjusted for inflation when that 30 year period likely occurred (1926-1956) and inflation adjusted that is worth $974 in 1926. In other words, your portfolio with non-inflation adjusted withdrawals went nowhere over 30 years. Not a bad outcome necessarily, but your portfolio purchasing power didn’t grow by 50% either

https://www.calculator.net/inflation-calculator.html

If you take the other end of the spectrum and the best outcome of $16,893 (16.9x gains) and adjust for inflation over the likely 30 year period (1965-1995) and the inflation adjust gains are actually 3.5x, not 16.9x. Again, that also doesn’t take into account inflation adjust withdrawals that would be much higher

What is the 4% Rule (of Thumb)?

“Rule of Thumb: The English phrase rule of thumb refers to a principle with broad application that is not intended to be strictly accurate or reliable for every situation.”
https://en.wikipedia.org/wiki/Rule_of_thumb

The Trinity study when published had one key conclusion: “For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behavior.”^[1]The data and those conclusions gave birth to the concept that a 4% withdrawal rate is a safe withdrawal rate (SWR) implying that you’ll never run out of money.

The danger with calling it a rule is that it implies that it will always work for all people. It is in fact a rule of thumb to guide you and give you a good target at the start of your journey, but you then need to consider your individual situation. Unfortunately humans are messy and do stupid things. If the market crashes and you sell your portfolio to cash none of this works. If you have a high bond allocation the portfolio success rates start plummeting over time.

Using the 4% Rule to Calculate your FI Number

The most common use of the 4% rule is to then use it to figure out what portfolio size you need to support a WR of 4%. That portfolio size needed to support the WR (often 4%) is referred as your financial independence (FI) number because you could theoretically quit your job at that point. The math is simple: 1/0.04 (4%) = 25. If your WR is 4% then your portfolio needs to be 25x your annual expenses to withdraw 4% of it per year. For example, if your annual expenses are $40,000 then multiply by 25 and you need a $1,000,000. If you change your WR to 3% then 1/0.03 = 33.33x and you need a $1,333,000 to support living on $40,000 a year.

4% Rule – Important Points to Remember in interpreting the Trinity study:

It doesn’t model extreme early retirement: The Trinity Study was not modeled around early retirees. It was modeled for standard retirement which is why the longest portfolio payout period studied was 30 years. Many incorrectly assume that if the portfolio success rate at 30 years is 100%, then it will also be 100% at 40, 50 or 60 years.
Sorry kids, you’re on your own. Good luck!: Portfolio success in the study is defined as having any money left at the end of the period. $1 left was success! That means that if you have aspirations of leaving inheritance behind then you need to factor that into your plan and choose a lower WR than you otherwise would if capital preservation wasn’t important.
Inflation, what inflation?: Only table 3 takes into account any kind of inflation. In other words, tables 1,2,4 assume that you withdraw the same amount in year 1 to live on as you do in year 30. Your expenses never go up with inflation and the table 4 terminal values are not adjusted for inflation. The study claims that using the Consumer Price Index (CPI) overstates the impact of general inflation on an individuals spending. In other words, 3% CPI increase doesn’t mean it will cost an individual 3% more to live the same. I’m not sure if anyone has proven this but I hypothesize that the less you consume by being more minimalist, the less that the consumer price index increasing would increase your life expenses. However, inflation is still going to always impact your life and some inflation should be factored in.
We don’t need no stinkin’ taxes!: The study leaves out any taxes, expense ratios, transaction costs and management fees. These are very independent factors so I can see why they left them out but they’re very much part of the real retirement world.
- If you have your assets are managed by a fund charging a 1% of all assets fee (AUM) then you now need to save up 33x expenses (3% withdrawal rate) to get a net 4% in your pocket. Ouch. If your expenses are $40k/year that’s needing $1,320,000 saved (33x) instead of $1,000,000 (25x) because of that 1% fee.
- Federal and state taxes also need to be taken into account. If you pay 15% in taxes between capital gains, ordinary income (401k withdrawals) and state taxes on your money then you need to withdraw $47,000 a year to net $40k for your expenses. That means having to save an extra $175k ($7k * 25x) before you can retire! Said another way, that 15% taxation makes your SWR effectively drop from 4% (40k/$1M) to 3.4% (40k/$1,175,000) forcing you to save 29.4x of expenses. Taxes suck.
Stock and Bond allocations matter: Higher stock allocations increase the likelihood of your portfolio will support 4% (or higher) withdrawal rates over longer time horizons. The best inflation adjusted success rates are all in the 50% or more stock portfolios. However, many lifecycle funds and traditional investing advice moves you into bond heavy funds in retirement. If your portfolio is large enough to cope with a 3% WR then this makes perfect sense. However, if you need a 4% or greater WR then only higher stock allocations will get you there. Don’t assume that the 4% rule will work for you if you have more than 50% bonds. it hasn’t worked historically and in lower interest rate and/or high inflationary environments it will only get worse.

Conclusions:

So what does this all mean for you? I think that table 3 of the study does show that based on historical data you do have a high likelihood (95%+) for success if you have at least 50% stocks, stay invested and withdraw an inflation adjusted net 4% of assets. You can’t extend the study to longer time horizons though so if you think retirement is 40 or more years I would plan on 3.5% unless you have other income sources or expect your expenses to decrease over time. I would recommend calculating in tax impacts and see the impact. You want a net 4% WR after taxes so adjust your FI number to include the impacts of taxes.

Action Steps:

Figure out your current annual expenses.
Calculate your FI number using the 4% rule. What is it?
If you’re closer to retirement calculate how much taxes may change your FI number.
Keep learning! Big ERN’s sequence of return series goes much deeper into the topic helping you apply this concept to early retirement. Highly recommended! https://earlyretirementnow.com/safe-withdrawal-rate-series/
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Article Sources:

AAII. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable” by Cooley, Hubbard and Walz. https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf. Accessed April 3rd, 2021.