At the end of 2021, my AIME will come in at $2,940. That comes to $35,280 annually.

If $35,280 seems low, that’s because it is. I make much more than that per year right now. The problem is about 15 of my 35 years have $0.00 in earnings. This averages down my number. That’s not to mention several other years of marginal fast-food wages.

But my $2,940 AIME figure is just the starting point for projecting my Social Security benefit. The Social Security Administration will only pay me a portion of this figure at retirement age. But how do I put a valuation on my Social Security benefit as things stand today?

As the Social Security rules stand, if I were to stop working at the end of 2021 permanently and never contribute another dime to the Social Security program, I would only get paid about 52% of my AIME at the age of 67. That comes in at about $1,518 a month or about $18,000 annually. Social Security calls this monthly benefit my primary insurance amount, and it’s indexed to inflation. But how do we get there?

Unfortunately, calculating our benefit is not as simple as multiplying our average indexed monthly earnings by a fixed percentage.

So, now we need the steps for solving for this new variable: Primary Insurance Amount.

Primary Insurance Amount

Last month we also verified I have the credits to qualify for Social Security at retirement. So barring no major changes in that realm of the program, I already qualify for a monthly benefit at retirement.

The Social Security Administration has a term to represent the monthly benefit we will receive at normal retirement age. It’s called the primary insurance amount. For those of us born after 1960, the normal retirement age is considered 67. Here is the definition directly from Social Security:

“The “primary insurance amount” (PIA) is the benefit (before rounding down to next lower whole dollar) a person would receive if he/she elects to begin receiving retirement benefits at his/her normal retirement age. At this age, the benefit is neither reduced for early retirement nor increased for delayed retirement.”

Social Security

Max likes to keep things simple. So in this post, we will stay away from early and delayed Social Security concepts. We will assume a normal retirement age of 67.

Social Security and Bend Points

As I mentioned, the Social Security Administration will use my AIME (currently $2,940/month) to determine my annual Social Security payment at retirement. But the program is not designed to replace my average monthly earnings completely. They are only going to pay me a percentage of what I made in my prime working years. And a lot like our marginal income tax tables, it is not a fixed percentage.  

As I mentioned above, this post will assume I retire at the full retirement age of 67. It will also assume I completely stop working at the end of 2021.

Here is how the calculation works: They break our payment into three different buckets. Social security calls each bucket a bend point because once we cross each point, we get less benefit for each dollar added to our AIME. This makes it much easier for those with a lower income to realize their benefit. They call it to PIA formula.

• (a) 90 percent of the first $996 of his/her average indexed monthly earnings, plus
• (b) 32 percent of his/her average indexed monthly earnings over $996 and through $6,002, plus
• (c) 15 percent of his/her average indexed monthly earnings over $6,002.

See now why the AIME is so important?

Max’s Calculation

Mrs. Max OOP is a math teacher. So I will make her proud here and “show my work” below. We are going to work through each of the buckets mentioned above.

Since my AIME is only $2,940 in 2021, I just need to worry about the first two buckets. 

The first bucket holds $996 and is the easiest to fill up. This one gets us the biggest bang for our buck. On the first $996 of my $2,940 AIME, Social Security will pay me 90 cents on the dollar at normal retirement age. This comes in at $896, or $10,757 annually and I am fully maximizing this bucket.

$996 X 90% = $896/month at retirement

As I said, Social Security refers to this $996 as a “bend point”. That’s because, once you pass $996 in AIME, Social Security only pays out $0.32 of every dollar added to your AIME at the time of normal retirement. That’s a pretty significant drop.

So now I subtract $996 from my AIME to calculate how much of the remainder is paid at 32%.

$2,940 (AIME) – $996 = $1,944 (AIME paid at 32%)

Now, I multiply this by 32% to get the rest of my projected payment for the second bucket.

$1,944 X 32% = $622

Add these together, I get my full projected monthly payment.

$896 + $622 = $1,518 payment per month in 2021 dollars

Multiply this by 12 to get my annual benefit.

$1,518 X 12 months = $18,221 in 2021 dollars

So, as I stand here in 2021, Social Security is theoretically set to replace 52% of my AIME.

$1,518 / $2,940 (AIME) = 52%

Final Thoughts

If I remain on my current trajectory, the Social Security program projects my monthly Social Security payment at $2,770 per month in 2021 dollars. That’s about $33,000 per year.

But that’s contingent on me continuing to work at my current earnings rate until retirement. If I do that, my AIME will continue to rise as I replace my $0.00 income years with much more significant amounts.  

But that’s a big assumption when doing long-term planning.

If I were to stop working at the end of 2021 altogether, my benefit would be reduced to about $1,518 per month or $18,221 annually. This is equivalent to an investment portfolio of approximately $450,000. So if I were to put a value on my Social Security benefit at retirement as of today, I think this is a better and more conservative number to use for planning purposes. I have essentially already earned it.

As we already know, $18,000 isn’t chump change to the Max Out of Pocket crew. An $18,000 annual benefit would cover nearly 40% of our 2020 living expenses (ignoring healthcare premiums). I would just need to make it to 67.

It sure pays to have a reasonable standard of living.

Will the Social Security program change? Sure. But Max is convinced it will be there in some shape or form particularly for those on the lower end of the AIME spectrum. I think this $18,000 will be there when I need it, and it will continue to grow with inflation.

How much would Social Security put back in your pocket at the age of 67 if you were to stop working today?

The post Social Security: Max’s Projected Payment appeared first on Max Out of Pocket.

By the end of 2021, the Social Security Administration will have taxed me on just over a million dollars in earnings. If we adjust all those years of wages for inflation, we are looking at about $1.2 million in taxed earnings. Over my entire working years, the total tax out of my pocket will come out to about $66,017 by the end of 2021.

A $66,000 contribution to Social Security. Not bad.

That is much less than I would have guessed. I contributed about that much to my traditional 403(b) retirement account in the last four years alone through my most recent employer.

In most cases, the Social Security Administration taxes our earnings before those dollars even make it into our pocket. If you make W2 earnings like me, your employer likely takes it directly out of your paycheck at a rate of 6.2%. There were a few years mixed in there where we only paid 4.2%. But nobody remembers that.

But is this really a tax, or a government pension?

This million-dollar milestone got me wondering: how much is this $66,000 contribution worth to me at retirement? And if I were to stop working at the end of 2021, then what happens? You won’t see a lot of people asking this question. Heck, most people don’t understand the basics of the Social Security program. But I think this is something worth understanding as we start some long-term tax planning.

To start down the path of figuring that out, we will calculate Max’s Average Indexed Monthly Earnings.  

Max’s Slow and Consistent Earnings

Let’s start with some personal history.

Compared to other people in my college-educated bubbles, my salary history somewhat resembles the Tortoise and the Hare story. I would describe my professional earnings as initially slow, but consistent. In recent years, they have grown much more exponentially. Frankly, I have earned a good portion of my wages over just the last few years. If we were willing to move again, I could likely get another significant jump in salary.

The thing was when I graduated from Michigan State University, I did not have a hard technical skill to sell. Sure, I had a fancy generic business degree, but that was about it. I remember several of my classmates with computer science degrees landing high salaried positions in Chicago and out West.

Max, on the other hand, would move south to Tennessee, start at a much lower pay rate, and slowly catch them over time. My basic strategy was to just beat my ‘spendy’ friends on the expense side of the equation in those early years. Since my first job was nearly 100% travel with my employer covering most of my expenses, that was pretty easy. Hotels and free food pretty much covered everything. Could I have made a few moves differently to increase things on the salary side of the equation more quickly? Sure. But I am happy with how things panned out.    

Social Security – A Snap Shot

Let’s hit the basics of Social Security.

In 2021, the Social Security Administration will tax us 6.2% on all earnings up to a cap of $142,800. They don’t touch anything over that amount. This tax does not hit our investment income, only earnings from our jobs. Our employer also pays 6.2% into the program. They increase the cap each year, and I do not currently hit the $142,800 threshold. Things paid through a cafeteria plan like healthcare premiums are sheltered from the tax.

Those who do hit the income cap would pay a maximum of $8,854 into the Social Security system in 2021. Their employer would match that with another $8,854, for a total of $17,708.

Qualifying for the social security benefit at retirement age is a lot like school – you need enough credits to graduate. Forty credits, to be exact. Graduating takes about ten years of work since you can only receive up to four credits per year.

Qualifying for the four credits in any given year is not difficult. In 2021, you only need to make $5,880 to get all four credits. Many higher-income professionals can earn all four of their credits during the first couple of weeks of the year. I am sure some earn them in the first few minutes after the New Year. There is no “extra credit” either; the maximum number of credits you can get each year is four. You can check out your progress and get all of your earnings history over on the Social Security website.

Finally, we know Social Security is currently only funded through 2034. So there are likely structural changes in store for us prior to retirement. They could change the tax rate, go after investment income, or even bump back the age for eligibility. Either way, I fully expect this benefit to be there in some shape or form at the time of my formal retirement.

Max’s Social Security Credits

I earned most of my 40 credits well before I was even considered a ‘professional.’ A good chunk of those first forty credits came from cutting up chicken at Boston Market and delivering packages for DHL. Some days, I miss those jobs. So as I write this, I already qualify for Social Security benefits at retirement age.

According to the Social Security website, if I stay on my current income trajectory, I will gross about $2,770/month ($33,240 per year) at the full retirement age of 67 (in 2021 dollars). That’s enough to cover about 71% of our 2020 expenses. That doesn’t even including Mrs. Max OOP’s Social Security.

If I am healthy enough to hold my retirement until age 70, I will gross $41,472. We spent $46,207 in 2020. I consider this a good sign that contrary to popular opinion, Social Security is a good play to help us maintain our standard of living during our traditional retirement years. I am obviously not accounting for healthcare expenses.

But, as the website states, that is contingent on me working until retirement at my current earnings rate. I like this concept, as it encourages productivity.

But what would happen to my benefit if I were to completely stop working in 2021?

If we were to move to Canada or Australia one day, I suppose that could theoretically happen. I could potentially take a long hiatus from Social Security contributions.

Average Indexed Monthly Earnings

To understand the current value of my Social Security benefit, we need to start with my Average Indexed Monthly Earnings (AIME). Don’t let that word “indexed” scare you. Let me break this down.

• Average, because they average our highest 35 years of earnings.
• Indexed, because they adjust those earnings for inflation.
• Monthly, because it is reported back as a monthly figure (not annual).
• Earnings, because it only includes earned income from a job, not investment income.  

The Social Security Administration uses our Averaged Indexed Monthly Earnings as the starting point for figuring out our benefit at retirement age. Right now, they consider the “full” retirement age to be 67.

They calculate our average monthly earning by averaging our highest 35 years of earnings. Their smart actuaries index our earnings to account for inflation.

For example, I made $2,734 at Boston Market way back in 2000 and that got me three of my forty credits. That figure is now worth $4,600 in 2021 dollars. You can find the index figures for each year here. They change every year.

$2,734 (wages earned in 2000) X 1.6824846 = $4,600 (value in 2021 dollars)

I worked all through high school and college, so I already have about 20 years of earnings on record with the Social Security Administration. My total earnings come out to about $1 million earnings over 20 years when I include my projected 2021 earnings.  

When we index all of the years for inflation, I come up with $1,234,730.

But even though I only have 20 years of earnings under my belt, I am still required to divide my total lifetime earnings by 35 years to calculate my average indexed annual earnings. In other words, they fill the earnings of 15 of my 35 years with big fat zeros. That brings down my average dramatically.    

$1,234,730 / 35 years = $35,278/year = Average Indexed Annual Earnings 

I then divide this by 12 to get my Average Indexed Monthly Earnings

$35,278 / 12 months = $2,940 = Average Indexed Monthly Earnings

This $2,940 is the starting point for my Social Security benefit calculation. It represents what I made on average per month during my highest-paid 35 years in today’s dollars.  

Final Thoughts

Taking the time to understand how some of this stuff works is a good use of time. A great place to start is calculating your AIME. You might find those years working at a fast-food restaurant still pay dividends.

I find this part of the calculation straightforward and simple math can get us there. We are averaging 35 years of earnings history and adjusting it to the current year’s dollars. This basic calculation gives us our Average Indexed Monthly Earnings. Since I am relatively early on in my career, my AIME is heavily averaged down by 15 years of $0.00 in earnings, and a handful of years of marginal fast-food wages. The chicken was good, though.

Therefore, at the end of 2021, mine will come in at $2,940. It will only go up from here.

But the Social Security Administration is not going to pay me $2,940 per month at retirement. I will only get a portion of that when I hit retirement age.

So, from here, things get a bit more complicated. When calculating our monthly benefit at retirement, the Social Security Administration only pays us a portion of our Average Indexed Monthly Earnings. But it is not as straightforward (think marginal tax brackets) so we will save that for another blog post.

What is your Average Indexed Monthly Earnings to date? 

The post Social Security: Max’s Average Indexed Monthly Earnings appeared first on Max Out of Pocket.

The Max Out of Pocket crew would meet the federal poverty guideline if we had an annual income of less than $17,420. That’s according to the Department of Health and Human Services (HHS). They will bump that figure to $21,960 in a few weeks when little Max or Maxine arrives and we turn into a family of three.

Now, it would be easy for someone like me to scoff at the number. But would I be scoffing at how low it is or how high it is?

“If it is not possible to state unequivocally ‘how much is enough,’ it should be possible to assert with confidence how much, on an average, is too little.”

Mollie Orshansky, American economist and statistician

I like to think we could easily live off $20,000 if we needed to. But that is easy for me to say. We are educated, established, and have more than a basic understanding of budgeting and personal finance. Some might go as far as to call it an obsession.

So, for Max, this stuff is simple.

Unfortunately, it is just not that simple for everyone, and plenty of people out there need help. We often use the federal poverty guidelines to get them the financial help they need.

But the HHS poverty guidelines are just that – a guideline. And a dated one at best. Plenty of government and private financial aid programs use it to determine eligibility for aid. Head Start and the Children’s Health Insurance Program are just a few examples.

We use it a ton in healthcare – but what it is it?

Poverty Guidelines vs. Poverty Thresholds

I need to start this out by level setting a few things.

Let’s start by calling out a distinct difference between the poverty threshold and poverty guidelines. The poverty threshold is used for statistical purposes, whereas we use the poverty guidelines for administrative purposes.

You might use them to answer two entirely different questions:

• How many people are in poverty? Poverty Threshold.
• Do I qualify for (insert government program here)? Poverty Guideline.

There is a nice FAQ page on the Health and Human Services website explaining some other differences.

That said, the poverty guideline is just a simplified version of the poverty threshold. The Census Bureau maintains the poverty thresholds and the Department of Health and Human Services maintains the poverty guidelines.

Mollie Orshansky

My understanding is the poverty threshold was initially developed by Mollie Orshansky way back in the 1960s. Evidently, we have not seen much change in the calculation since then. These days, the Census Bureau keeps the poverty thresholds up to date.

In a nutshell, Orshansky took the cheapest of four food plans developed by the Department of Agriculture and multiplied it by three. Why three? Because the 1955 Household Food Consumption Survey (also administered by the Department of Agriculture) suggested that families of three or more persons spent about 1/3 of their after-tax income on food. Then they adjusted the figure for family size. This relatively simple function defined the poverty threshold. 

There have been some minor adjustments to the calculation over the years, but not many. The consumer price index is used each year to adjust the figure. The base year (1963) was $3,128 for a family of four.

At the risk of beating a dead horse, I want to be clear that the HHS poverty guidelines are derived and standardized from the Census Bureau’s poverty thresholds. Although they are similar, they are simply not the same thing.

What are the Federal Poverty Guidelines for 2021?

The Department of Health and Human Services updates the federal poverty guidelines in February of each year. They generally apply retroactively to sometime in January. You can find them here.

There is one table for the 48 contiguous states and the District of Columbia. Alaska and Hawaii get their own because they are considering a higher cost of living for those areas. 

Here is the table for 2021:

The federal poverty guidelines are adjusted each year by the Consumer Price Index for All Urban Consumers (CPI-U). For 2021, this update reflects a 1.2 percent price increase between calendar years 2019 – 2020.

One thing I found interesting about the poverty guidelines is they do not distinguish between farm and non-farm families. They also do not differentiate between aged and non-aged families; they lump them together.

Lastly, the guideline does not distinguish between before-tax or after-tax income. Although the official poverty definition uses “money income before taxes”, the guidelines leave it up to the administrative program (like Head Start) to define how they want to use the table.

Using the Federal Poverty Guidelines

In healthcare, we often refer to the federal poverty guidelines as the federal poverty level (FPL). That’s bad practice.

The Department of Health and Human Services specifically calls out the use of the term “federal poverty level” as ambiguous. They caution against the practice of loosely using the term “federal poverty level” when precision is important. So, I will use the proper term, guideline.

When financial aid programs use the federal poverty guidelines for determining financial eligibility, it is often a multiple of the income limit. For example, a family of two may qualify for a particular program at 200% of the federal poverty guideline.

So, we start with the federal poverty guideline for a family of two, which is $17,420. We then multiply that by 2 to get $34,840.

$17,420 X 200% = $34,840

If your family income is less than $34,840, you might qualify for that program.

Final Thoughts 

The Max Out of Pocket crew could easily live off $20,000. But I need to be careful here. Me living on $20,000 is not even close to the same as someone struggling on $20,000; they are mutually exclusive.

The federal poverty guidelines are just that, a guideline that doesn’t account for education or other factors. I think it is something that could use some updating.

In 2020, we spent 2.65 times the federal poverty guideline for a family our size. But that does not mean we were living at 265% of the poverty level. Remember, the poverty level is not the same thing as the poverty guideline.

$46,207 (2020 Expenses) / $17,420 (Poverty Guideline) = 265% Federal Poverty Guideline

Additionally, our overall income far surpasses the guideline by several multiples.

The tables are updated annually each February and are derived from the Federal Poverty Thresholds, which the Census Bureau maintains. The poverty guidelines are used for administrative purposes, whereas the poverty thresholds are figures used for statistical analysis.

Many healthcare assistance programs use the guidelines for determining eligibility. Therefore, having a basic understanding of the tables is meaningful if you or anyone you know needs assistance.

Have you ever used the federal poverty guidelines for anything?

The post 2021 Federal Poverty Guidelines appeared first on Max Out of Pocket.

We sometimes refer to this as earned wages. But before it hits my pocket, my Uncle Sam takes his share. He calls it wages, salaries, and tips. These wages hit Line 1 of the 1040 tax form, and the government taxes us from there.

Whatever money is left lands in my pocket.

For a lot of us, it ends there. We live our life trading time for money.

But the money left over is called capital. It’s ours. We are free to spend it, save it, or invest it. Since I have always been interested in freeing myself from the need to work, I tend to focus on the latter. As such, I have elected to invest a substantial portion of our left-over earned wages over the years. In most years, well over 50% of our after-tax income has been saved and invested. Luckily, Mrs. Max OOP has been on board with this plan as well.

But just like trading my time for money, when I invest my capital, I expect a return for my investment. This return comes in the form of interest, dividends, or capital gains. Those land in my pocket too, but my Uncle Sam also wants a piece of this.

So how did we do in 2020? Since it is tax time, let’s take a peek.

Taxable Brokerage Income vs. Retirement Account Income

The majority of my investment activity over the years occurred in tax-advantaged retirement accounts. Therefore, plenty of dividends and capital gains land in those accounts. But I do not need to worry about being taxed on that income for years. It’s not taxable until I retire, so I did not include it in the numbers below.  

The fact is, the majority of our passive investment income hits our retirement accounts.

That said, the last several years have seen a lot more investment activity in my taxable brokerage accounts. These accounts generate taxable dividends and taxable capital gains. These taxable investment returns are something worth keeping an eye on.

Ordinary Dividends

Dividends are generated when a company I own shares some of its earnings with me. In 2020, our ordinary dividends came in at $4,288. This number is up 35% from $3,168 in 2019.

We can break this $4,288 into three different buckets.

• Qualified Dividends – $1,405
• Non-Qualified Dividends – $2,029
• Section 199A Dividends – $853

Max likes qualified dividends because they are efficient for tax purposes. The Max Out of Pocket crew paid a healthy 15% tax rate in 2020 for qualified dividends. Total market index funds held in my brokerage accounts generated most of these qualified dividends. 

My non-qualified dividends are not as sexy. They are taxed at a higher rate just like my regular earned income. More than 50% of the $2,029 in non-qualified dividends were generated by my “$100,000 opportunity fund” in late 2020. These dividends will be hit with a 22% tax, and it demonstrates just how tax-inefficient that fund is.

Finally, we can look at our Section 199A dividends. These get taxed just like regular earned income, but I get a special tax deduction on those. The medical office building REIT stock portfolio held in my taxable brokerage account generated almost all of the $853 in Section 199A dividends.

Capital Gains

A lot of people harvested capital losses when the market tanked back in March 2020. But for us, 2020 was a year to focus on positioning. I used 2020 to clean up our account structure and develop an investor policy statement. I sold some losers, moved around some winners, and cleared an $11,229 capital gain in the process.

Surprisingly, his number is flat compared to the $11,930 in capital gains we had in 2019. Almost all the 2019 capital gains were considered long-term and were taxed between 0-15%.

We were not so tax efficient in 2020.  

In 2020, about $6,911 of our capital gains were short-term capital gains, taxed like regular income.

Another $4,318 was long-term capital gains. Those will be taxed at 15%.

$6,911 (short term capital gain) + $4,318 (long term capital gain) = $11,229 total capital gain

Non-Dividend Distributions

Non-dividend distributions were a new concept for me in 2019. I received another $606 in non-dividend distributions in 2020, mostly from the medical office building REIT portfolio. This figure does not hit our tax return anywhere, so I did not count it as investment income. We won’t get taxed on it in 2020.

However, it is worth noting for cashflow purposes and I think there is a lot to explore here.

I received the $606 distribution in cold hard cash, but it also reduced my cost basis on that investment. Therefore, this will eventually come through as a capital gain on my tax return. We will pay 15% tax on that at some point, and maybe less if I plan carefully. 

Total Investment Income

So, our total investment income for 2020 came in at $15,517.

$4,288 Ordinary Dividends + $11,229 Capital Gains = $15,517

Unfortunately, that $15,517 is not free and clear. My Uncle Sam takes his piece before it hits my pocket.  

Federal Taxes

Thankfully, the Max Out of Crew doesn’t get hit with FICA taxes on our investment income. But we do get hit with federal income taxes.

In years past, I always prioritized tax efficiency on my investment income. I often accessed the 0% capital gain tax bucket early on in my investing career. In 2021, the long-term capital gain tax rate on taxable income under $80,800 is 0%. That’s a number young investors should keep an eye on.

But 2020 was a clean-up year, so I willingly paid a decent chunk of tax on this income to clean up my account structure and tighten up our investor policy statement. It was money well spent.

We will pay about $2,976 in taxes on this investment income from 2020. That only about 19%, and will leave us with $12,541 in our pocket.

$15,517 investment income – $2,976 taxes = $12,541 net income 

State Taxes

Our total state tax on investment income came in at $0.00.

The Max Out of Pocket crew has been hiding off-grid in one of the 9 states that have no income taxes. So, I did not need to worry about state taxes in 2020.

That said, my state does go after dividend income when it hits $4,800 for married couples. We have about $512 left in that bucket and will keep a close eye on things.

Final Thoughts

I sometimes want to tell everyone I know about passive investment income. Unfortunately, it seems odd to talk about this type of thing at parties. So I blog about it instead. And since it is tax season, now is a great time to review these things.

A lot of people complain about tax rates or how rich people get taxed. I usually assume a majority of those people don’t understand how they themselves get taxed. Since it impacts their day-to-day, it’s worth looking into.

Our total taxable investment income for 2020 came in at $15,517. This is up $419 from 2019 ($15,098).

After Uncle Sam took his share, we were left with $12,541 in our pocket. That covered over 27% of our 2020 expenses.

$12,541 Investment Income / $46,207 Expenses = 27%

As someone who considers himself just an Average Joe Max, I think this is pretty amazing. But I also know there are plenty of people out there that can easily 10X these figures.

Ultimately, I consider this 12,541 seeds. Seeds for us do to do as we please.

That $12,541 will be invested in other companies that will likely generate even more dividends and capital gains in future years. And I am just getting started; this number has years to grow.

How did your 2020 investment income look?

The post Our 2020 Taxable Investment Income appeared first on Max Out of Pocket.

Tilt: move or cause to move into a sloping position.

As they tout their tilt, I sometimes have a hard time reading between the lines to understand the why. Do they know something I don’t? Do they understand this risk and reward relationship? 

The thing is, many of these investment experts aren’t experts at all. Just like Max, they are completely random characters from in and around the internet. So be careful following advice from the internet masses without fully understanding the risk. That includes me.

I suppose everyone is happy this isn’t another baby post; let’s stick with personal finance today.

Total Stock Market Index

I remember stumbling across Vanguard when my wife worked for a small school down in North Carolina that did their 403(b) through them. I immediately noticed how low their fees were compared to some of my previous workplace accounts. My understanding is its founder is the one who made index fund investing available to the average Joe Max. He passed away just over two years ago.

Don’t look for the needle in the haystack. Just buy the haystack!” 

Jack Bogle, Vanguard founder

Historically, I have always been mostly invested in market-cap-weighted total stock market index funds such as the now-famous VTSAX. The goal was simple. I piled as much money as possible into the total market and did not worry about squeezing an extra 0.5% return while the balance was immaterial. Salary, career progression, and expense management were much more valuable and could move the needle quicker than investment returns.

That led me to buy a piece of all 3,600 or so companies available on the public stock exchange and leave it at that. When the total stock market wasn’t available, I would settle for the 500 companies that are part of the S&P 500. Either way, we are talking about purchasing large sections of the US economy here. Haystacks.

But as balances grow, so does strategy.

As I developed my investor policy statement in late 2020 I worked on rationalizing my risk tolerance. In particular, I looked closely at my US equity allocation. I decided it was finally time to tilt my way into small caps. I am using a lesser-known Vanguard fund called VSMAX to make that happen. 

Initially, I considered buying haystack healthcare-focused companies. Ultimately, I decided against it due to lack of diversification from my livelihood, healthcare finance.

My motivation for this small-cap tilt is risk management and hopefully some reward in the long term. It will be a slow process, probably years in the making.

Small-Cap Stocks

According to Investopedia, a small-cap company is a company that has a small market capitalization. Their definition suggests a market capitalization range of between 300 million to 2 billion dollars.

My writing surrounding my ‘pet’ medical office building portfolio was primarily focused on Physicians Realty Trust (DOC). Physicians Realty Trust has a market capitalization of $3.54 billion at the time of writing this. That puts them out of range for this narrow definition. 

We get the market capitalization by taking the number of shares and multiplying it by DOC’s current stock price.

208,230,000 Shares X $17.00 Per Share = $3.54 billion

You can also just look it up if you have a hard time with multiplication.

I currently own about 1,200 of those 200 million shares in my taxable brokerage account. As an owner, the company pays me about $1,000 every year in passive income. That covers over 2% of our annual living expenses.

$3.4 billion is a drop in the bucket compared to Tesla’s market capitalization of about $648 billion. That’s more than half a trillion dollars. Coca-Cola comes in at about $210 billion at the time of writing this. Etsy has a market capitalization of about $27 billion. 

So, none of these companies meet the Investopedia definition of a small-cap company. So they must be too big to fit into my small-cap VSMAX haystack, right? Wrong.

Interestingly enough, I found a few of them in my index fund.

Buying an Entire Haystack of Small-Cap Stocks

As I mentioned, I generally consider myself an index fund investor. I occasionally play around with individual stock for excitement and education, but that generally represents less than 10% of our portfolio. I know better than to scour the entire stock market for that one needle that will outperform everyone else.

So, when I look to tilt my portfolio in a certain direction, I tend to use giant haystacks. Not individual stocks.

In this case, the haystack is VSMAX, and it currently holds about 1,420 companies. Like most things at Vanguard, it is really cheap to own, with an expense ratio of only 0.05%.

Yes, it has my name, Max, in it. No strategy there, purely coincidental.

As I poked around this fund, I was surprised to find it holds both Physicians Realty Trust (DOC) and Etsy. That’s because Vanguard has its own definition of small-cap companies. The definition is a bit technical and not something I am looking to cover today. But it certainly threw me off at first.

So when I buy this index, I am essentially buying these companies along with 1,418 other companies.

Small Caps and Risk

Small-cap companies are generally more volatile and come with more risk than their obese friends. In some cases, newer companies do not have a solid foothold in their industry yet and struggle to compete. But sometimes, their growth can be explosive. We all know Coca-Cola will hold its value and probably outlive me by hundreds of years, but it’s much harder for it to grow because it is already so big. That’s where small-cap stocks come in.

VSMAX gives me a blend of value and growth, which is likely why they let some of those larger stocks in there like DOC.

Vanguard does a great job calling out the risk the comes along with owning small-cap stocks. They created a bar graph to help people visualize the risk a little better. VSMAX hits the highest number on the risk-o-meter. 

We can compare this with the total stock market index fund, which only hits a 4 on the same meter. 

Why is Max Taking on More Risk?

A few things to call out here. I have read a few pieces about how much of the total stock market is made up of Facebook, Amazon, Apple, Netflix, Alphabet (Google). They call them the FAANG stocks, and we are talking mega-cap companies. Amazon comes in at $1.6 trillion, close to the almost approved $1.9 trillion dollar stimulus package.

In theory, because the entire market (VTSAX) is market-cap weighted, it might make our portfolio a bit overweight with these companies when we own it. 

I will add a few to the list. 

These ten companies (out of 3,600) make up 23.60% of the total stock market index as of January. I have enjoyed long-term success as the total stock market index reaped the rewards from the value created by these world-class companies over the last decade or more. But in my eyes, our portfolio has become a bit overweight with assets from these ten companies alone. So, I am looking to tilt my diversification (ever so slightly) away from them. 

Flash Back to 1992

In 1992, the top ten holdings in this fund looked very different and only encompassed about 14% of the fund. It included companies like Exxon Mobil, Walmart, and General Electric. 

FAANG stocks will likely dominate the industry for years to come, but I also know a whole generation is coming up that refers to Facebook as “mom book.” How will that pan out for Facebook 30 years from now? Even I stopped buying Apple products years ago, and Paramount got my attention with their Superbowl ads. We might ditch Netflix to get more access to sports (they are no longer in the top 10).

It’s not just Max, regulators are also looking at their size. 

There is much more to discuss here, and some of it is out of my league. So I will leave it at that. I probably do not understand the technicals and self-cleansing nature of the market, but the overarching argument makes common sense to me. Common sense isn’t that common anymore.

The top ten companies in my small-cap haystack look quite different and only represent 3.6% of the entire index. This is the type of diversification I am currently on the hunt for.

I just looked up Plug Power – they are building the clean hydrogen economy. Glad I could do my part investing in clean energy.

Final Thoughts 

Max doesn’t have a crystal ball here. Odds are I will lose. I have to go back 20 years to find a period of time where this small-cap index actually beat the total stock market index on an average annual performance basis. The margin is about 1.86%.

But I also know 1.86% on a million dollars is $18,600 in one year. Multiply that over 20 years, and it is something worth looking into. I have also read that small-cap stocks might be better positioned to come out of the pandemic stronger since they are lean. Most importantly, I don’t think this is breaking the first philosophy bullet of our investor policy statement.

Automation, Simplicity, Systemness (*I like this word)

Our portfolio will always own a big piece of VTSAX, but tilting doesn’t hurt. I have thought about playing around with “equal-weighted funds” in place of market-cap-weighted funds. But for now, I am happy to (very) slowly tilt our portfolio into a small-cap arena to offset some of the imbalance I perceive in the total stock market index. My $100,000 opportunity fund has given me some confidence to take on this additional risk.

Since early January, I have moved close to $25,000 in that direction. I will eventually set an allocation for rebalancing purposes and forget it.

Do you think small-caps are worth looking into? Are there books worth pointing me to? Thoughts on pushing from blend to growth?

The post Touting My Tilt: Small-Caps, Haystacks, and Max appeared first on Max Out of Pocket.

Outside of Healthcare finance, Max prides himself on being in tune with the personal finance world. However, I have been known to get off course from time to time. As such, I occasionally drift away from my overall strategy and philosophy. In other words, I make things more complicated than they need to be. Ultimately, I chalk all this up to me not formally writing down our strategy. 

As much as I hate to admit it, I do have capacity limitations. I still have a career to manage and other goals. With 2021 shaping up to be a busy year, keeping things simple is important. So, I have been doing just that – simplifying my financial life by following the very principles I preach.

In late 2020 I consolidated several accounts, which included an old and dusty health savings account. I took a hard look at our assets allocation and cleaned up my brokerage account. I even sold off some old individual stock purchases that had aged out. This is all momentum I plan on carrying into 2021.

To make this project successful, I have decided to go ahead formalize a 2021 Investor Policy Statement for the Max Out of Pocket crew. 

What is an Investor Policy Statement?

Others on the internet regularly talk about having an investor policy statement. I read about this concept years ago and thought it was a great idea. I even recall Physician on Fire mentioning it several times when we were talking finance down in Ecuador. But I somehow fell short of implementation.

An investor policy statement is meant to be high level and provide “general direction” for investment goals and objectives. According to Investopedia, specific information on matters such as asset allocation, risk tolerance, and liquidity requirements are included in an investor policy statement. It should also include specific plans to meet those goals. 

I like to consider it overarching, kind of like a mission statement. So without further ado, here is Max’s investor policy statement.

Subject

Max Out of Pocket’s 2021 Investor Policy Statement

Overall Objective

Develop a simple and mostly automated financial plan that maintains a position of financial independence, stability, and growth while releasing myself of frequent decision making.

2021 Specific Objective

Continue to focus on liquidity/access to dollars, building up tax-exempt retirement accounts, correcting our target allocation, simplifying account structure, and tilting more into small caps equities.

Philosophy

• Automation, Simplicity, Systemness (*I like this word)
• Use mostly index funds to access large portions of the total stock market and accept those returns
• Focus on balancing retirement goals while tilting more towards current goals (here and now)
• Still allowed to have some fun with speculative investments, but must keep it simple

Risk Tolerance and Liquidity

We have strategically created an oversized fixed emergency fund and opportunity fund to the point of redundancy. Therefore, we have an extremely high-risk tolerance on all other assets.

Definitions

• Our portfolio is split into four categories:
  • Taxable liquid
  • Tax-deferred retirement
  • Tax-exempt retirement
  • Health savings account (60k)
• The majority of assets live within the following firms:
  • Vanguard – Wife’s IRA, Max’s taxable brokerage with index funds
  • Fidelity – Max’s IRA, Max’s taxable brokerage with individual stocks (3)
  • Lincoln Financial – Max’s active employer 403(b)
  • Health Equity – health savings account
  • US Treasury Direct – I bond ladder

At this point, there is no option for account simplification outside of collapsing Fidelity into Vanguard. I am unwilling to do that at this time; no strategic reason, just preference. It’s certainly not out of the question for 2021.

Evidently, spouses cannot collapse their individual traditional IRA’s into a jointly owned IRA, which is unfriendly. Someone, please correct me if I am wrong on that or if you know of any workarounds.

Target Allocation

Our overall allocation target for our entire investment portfolio is outlined below. I hope to explain this further in a future post.

Hopefully, this adds up to 100%:

• 40% United States equities via low-cost index funds
• 20% International equities via low-cost index funds
• 20% Bonds (this includes our fixed emergency fund, fixed opportunity fund referenced above, and a large I Bond ladder I created)
• 19% Alternatives including REITs, the REIT MOB portfolio, and other speculative investments
• 1% Crypto (I should know better but can’t help myself)
• 0% Cash and cash equivalents

Overall, only 10% of our overall portfolio can be speculative investments, which will eventually include cryptocurrency (Yes, I know cryptocurrency is a currency, not an asset class). I define speculative investment as any individual stocks, which still includes my medical office building portfolio.

As of 12/31/2020, we were at about 9% speculative.

Here is where things were as of 12/31/2020:

Max clearly has some work to do here, and it shouldn’t take me too long to straighten some of this out. I have generally been closer to 75%-90% US equities but I have gotten soft in my old age.

As for the current 14% in US equities, much of that is timing. Some money was being moved around towards the end of the year when this data was populated. Much of that has since settled back into US equities. In particular, a larger transaction of the fidelity bond index (FSNAX) that is landing in equities after 12/31/2020 year-end. In other words, things are stabilizing, but I will still have some work to do in the coming months.

I plan to look at this monthly going forward, similar to how I used to handle our income statement and expenses.

Narrative

After establishing a 50k emergency fund and a 100k opportunity fund in 2020, we have become overweight in cash (currently 6%) and bonds (currently 34%). To correct this, almost all 2021 investment activity below will be directed towards US stocks (14% at year-end). This will mostly be in small-cap index funds through FSMAX.

There are also some large transfers occurring in January 2021 that will move some investments currently classified as bonds back into US Equities.

As my government I Bond ladder matures, I will also likely slowly release our 50k emergency back into equity investments. I haven’t had a chance to cover this much on the blog yet. Additionally, we are slightly overweight in REITs (26%) and I am dealing with that.

Although I have concerns about liquidity and focusing too much on retirement years, I am still leaving the option of maxing out retirement accounts in 2021. That said, all contributions must be tax-exempt ROTH contributions.

I placed too much priority on tax-deferred accounts in my 20s in order to boost our net worth. There were plenty of benefits to this, but these days I am more interested in paying the tax now. Those tax-deferred contributions were in 100% equities for over a decade and have grown to a point where I am concerned about required minimum distributions (RMDs) and our tax burden in retirement years. It is possible for your tax-deferred accounts to get too big, and there are plenty of outdated articles that cover this. I was also considering extreme early retirement options at the time, which I have backed away from in the last 18-24 months. That makes a Roth Conversion ladder challenging for me.

Allocation Correction

There is a need to reduce our bond position by a large sum and it will likely take all of 2021 to make that happen. Aside from the short term correction, I still need to increase our US equity position by more than I will even make with my salary this year.

This will be done through dollar-cost averaging current salary and also replacing some bonds with equities. Unfortunately, I don’t have a great way of automating that process. Although I know lump-sum investing usually wins, I will likely move about $500 a day from bonds to equities to make it easier to accept should the market tank.

The 6% cash is partially related to a poorly timed health savings accounts consolidation. The timing was not my fault; the HSA company required me to sell all assets (US equities) and took their sweet time moving the money to Health Equity while the overall market continued to rise. I have not bothered calculating the cost of the transaction, but I am sure it is in the thousands.

We will continue to live modestly on about $50,000 in 2021 to allow for a higher than normal savings rate. I also plan to immediately reduce our $51,436 emergency fund to match our 2020 spending, which came in at $46,207. That will drop another $5,000 into US equities in the first few months of 2021. This is more symbolic than anything, but I like the practice and symbolism can be important.

Process

• I have the option to max out our tax-exempt Roth 403(b) in 2021 with $19,500. This is one decision I am leaving open-ended. My Lincoln Financial 403(b) currently sits at about $75,000 and is fully invested in VIIIX. This is basically the S&P 500, and it is the best and cheapest investment my employer offers.
  • The goal could be to get this account to $100,000 since we can take a low-cost loan on 50% of the balance up to $100,000 (meaning up to a $50,000 loan).
  • This supports our goal of access/liquidity should we need it. I am starting the year with a 5% automatic Roth contribution to my 403(b) to ensure I get the 4% employer match.
  • The 4% employer match is also automatic and considered tax-deferred. This is a 1% increase from the prior year due to a consolidation of my department at work.
• Max out the health savings account at $7,200 in quarterly contributions.
  • Max’s employer contributes $600 of this limit in early January.
  • The balance of the limit ($6,600) will automatically occur in four $1,650 transactions in early March, June, September, and December.
• Max out both Roth IRAs at $6,600 for 2020 and 2021. This contribution will become liquid again in 5 years if needed. The timing of this contribution is TBD, but the sooner the better. Max’s ROTH IRA is already maxed for 2020.
• All other funds are invested in liquid brokerage accounts after meeting monthly expenses, mostly hitting FSMAX initially.
• Both the emergency fund and opportunity fund have very specific criteria for accessing them, and balances can only be reviewed annually. Those scenarios are documented separately.

Future Considerations

• Consider using a “fixed” bond allocation vs. percentage of net worth
• Potentially use ultra-short-term bonds for the emergency fund
• Figure out an allocation “cap” for the health savings account as the balance is quickly approaching 100k
• Formalize a drawdown strategy
• I could see landing at 50-60% US equities, but changing this too much is not acceptable.

Baby and Other Personal Notes

• We have our first child on the way. I am projecting out-of-pocket costs in 2021 of $6,600, which represents our full max out-of-pocket. Therefore, I will likely keep a small $6,600 cash allocation in my health savings account. Slightly redundant, but I also think this is best practice and I want to set a good example. We have considered birthing the baby in Canada, in which case we would dump this $6,600 back into equities.

• Mrs. Max OOP is still teaching one class remotely which will gross about 10k annually. It is a niche class (AP Stats) and she can likely keep it if she chooses to do so. She is also now a certified butcher, a skillset that we may monetize at some point.
• Mrs. Max OOP’s low income keeps us in a favorable tax situation, which is part of the reason I am utilizing tax-deferred accounts so much.
• As we read about feeding options and our sleeping goals, we are seeing a need for Mrs. Max OOP to stay home and focus on the baby for several months after arrival.

*Systemness – saw this word on an EPIC corporate presentation during a pre-implementation meeting. I got a kick out of it and assumed they made it up. Now I know it is likely a real word.

I am not a financial advisor, so it is not advisable to copy me on any of this. You are always responsible for your own financial decisions. This document will likely be updated with minor changes throughout the year, mostly for clarity and as I firm up a longer-term strategy.

The post Max Out of Pocket: 2021 Investor Policy Statement appeared first on Max Out of Pocket.

But most of us never will. We will just keep on spending our way through life wondering why we can’t get ahead.

I could argue that tracking expenses should be at the bedrock of any sensible personal finance strategy. At the start, managing expenses is more important than investment choices, expense ratios, and to some extent, even salary. Personal finance is very much behavioral, and spending is the starting point of that behavior. Tracking expenses is just a way to measure it.

And what’s measured matters.

I have always recommended tracking expenses manually in Excel. Automation makes sense at some point, but there is something to be said about doing things manually in the beginning.

I have always dubbed our annual expenses as “a reasonable standard of living”. Frankly, it’s beyond reasonable. I personally think we live it up on about $50,000 per year. But where I see happiness and efficiency, others might see deprivation.

For Max, the value in reviewing these numbers has diminished over the years. That said, I am only providing this information because years ago I found having an online “compare group” beneficial as I firmed up my personal finance strategy. It helped me set baselines.

So, taking the time to download my credit card statement history and pivot it into a nice summary is my way of paying back to others who might be taking that first hard look in the mirror. Now, they might have someone to compare to.

So what’s the damage?

In 2020, the Max Out of Pocket crew spent $46,207. This is exactly $5,229 less than we spent in 2019. 

Here is how things looked in 2019:

Housing

We dropped another $12,000 on housing in 2020. Plenty of people would tell me I am throwing my money away on rent, but I know it is not that simple. Thankfully, this expense has remained flat for 2018, 2019, and 2020. I am not projecting an increase for 2021 unless we move. We have been renting the same place in northern New England since we sold our house down in North Carolina.

This represents about 26% of our total 2020 expenses. I consider it money well spent since it is meeting one of our basic needs – shelter.

Food, Dining, and Groceries

Speaking of basic needs, food is up next.

In total, we spent $9,723 on food, dining, groceries, and a three-month college meal plan in 2020.

This group includes things like groceries, eating out, and alcohol. For the Max Out of Pocket crew, groceries consist of things beyond food items. Cleaners, paper goods, and personal care items land in our grocery line. A few specific examples are things like shampoo, dishwasher detergent, and toothpaste or toothpicks.

In 2020, Mrs. Max OOP spent 16 weeks studying abroad in Alberta, Canada. She lived right on campus so we dropped $1,885 (USD) on her meal plan which is included in the number above. This made things very convenient and she could focus on her studies and being pregnant.

Max was left to fend for himself. It’s amazing how much food you can buy in exchange for less than an hour of work.

We also somehow spent $1,350 at restaurants and coffee shops. This would include “carry out” after the pandemic hit. Although this total came in higher than expected, it was $1,400 less than in 2019. We probably spent more than $300 eating out at nice restaurants during our visits to Cape Cod over the summer.

One accomplishment from 2020 is we had three solid months where we did not eat out at all. I do not recall this ever happening since I started tracking this type of thing. April, May, and November we did not spend a dime at restaurants and coffee shops.

I also took over a month off drinking alcohol, so we spent $0.00 on the substance in October.

Utilities

Utilities include things like electricity, oil, internet, cell phones, and our Netflix subscription. Yes, I still call Netflix a utility. I categorized this line as a “utility” years ago and just left it there mostly because it is incurred monthly.

In total, this category came in at $4,883.

Here is a side by side from the prior year. Most of the increase can be attributed to a new cell phone (Pixel) for Mrs. Max OOP. I continue to get nickel and dimed by our internet provider and I am not sure why I don’t just deal with that.

Auto & Transport

Mrs. Max OOP and I both drive aged-out Hondas (07′ Civic / 08′ Odyssey). Over the summer I was seriously considering upgrading one of our vehicles to a newer mid-sized SUV. I was even talking about it with friends and family, which usually is a tell-tale sign that Max is getting serious about something. However, with Mrs. Max OOP in Canada, making a new vehicle purchase really did not make much sense.

We only spent $2,128 in the auto & transportation category.

Almost half of that went to gasoline. I biked to work during the summer for over 6 weeks straight. Another $528 went to our auto insurance. I know some people who spend close to that each month on car insurance in my home state of Michigan.

2020 was a nice year for the “service and parts” category, coming in at only $388. Most of that came late in the year when I was forced to replace my rear brakes during a routine annual inspection. I didn’t include the cost of the Labatt Blue in the repair.

Lastly, we dropped another $250 on property taxes for the vehicles.

Miscellaneous

My other/miscellaneous category has everything else dumped in it. For 2020, this came in at $16,308. Just like last year, I feel like I have some explaining to do here.

Following an 80/20 rule, my goal is to quickly identify where 80% of this money went.

Here is $13,702, representing 84% of this category.

Mirror on the Wall

• $3,997 on our damn cats. This was mostly for therapeutic treatment for our cat Charlotte, followed by end-of-life care. She was a great cat, but 4k seems steep and represents almost 25% of this category. We will see a nice reduction to this in 2021.
• Mrs. Max OOP dropped $2,262 on tuition for 16 weeks of training on how to become a butcher. This was partially subsidized by the Canadian government because she is a Canadian citizen.
• We spent $1,394 on a two-week hotel stay in downtown Calgary, Alberta. This was during our initial quarantine to get set up for the program.
• I have $1,242 labeled “shoes and clothing”. This seems high again, but I have not drilled too deep into it.
• We spent $753 on a two-week rental car in Calgary, Alberta when moving Mrs. Max OOP out there. This was a bad purchase considering we were in quarantine most of the time, but we felt it was required to keep others safe considering the pandemic.
• Mrs. Max OOP bought a new computer with a touch screen for $702.
• $627 is labeled “gifts” – this includes gifts to family and other donations.
• Spent $550 on firewood. I could make the argument this is technically a utility, but we use it more as a luxury item since the fireplace is not the most efficient way to heat the house in our current setup.
• $536 on other hotels during travel to and from Alberta, including a “park and ride” hotel here in New England.
• $501 on air travel to and from Alberta for butcher training.
• $365 on my gym membership after two months were waived during the March/April shutdown. About $200 of this is now paid back by my employer through healthy benefits, but I consider that income and don’t reduce the expense.
• $191 for a new United States passport for Mrs. Max OOP. We paid for United States citizenship out of 2019’s spending.
• $162 on haircuts, mostly for me; Mrs. Max OOP cuts her own hair.
• I spent $151 on this blog.
• $133 golfing in the mountains.
• We spent $101 on our post office box.
• $35 renting a mountain bike.

So, here is where Max will show you his advanced blogging skills by busting out “gallery mode”. These photos represent discretionary spending at its finest, although Mrs. Max OOP will argue the expensive cat care was not discretionary.

Here is a giant Calgary avocado, meat camp, a $3,000 cat, golfing, and the Bow River. A nice look at 2020.

Healthcare Services

Since we consider Max Out of Pocket the intersection of healthcare and personal finance, I feel compelled to further break down our healthcare category this year. This section does not include our insurance premiums since my employer heavily subsidized those costs. I don’t think my portion of the premium cost represents much of anything. That said, we did cover my 2020 health insurance in detail earlier this year. It would cover 48.5% of our entire 2020 spending.

We spent $1,146 on healthcare in 2020. This was slightly higher than normal because Mrs. Max OOP is expecting! We paid cash for most of the obstetric services Mrs. Max OOP received during her studies in Canada.

Here is everything:

• $259 on dental work for me
• $231 for doctors’ visits in Alberta with Mrs. Max OOP’s OBGYN
• $83 for our first ultrasound on 9/18/2020
• $154 for a nuchal translucency ultrasound on 10/15/2020
• $108 for lab work in Canada on 10/15/2020
• $172 for a second-trimester ultrasound on 12/3/2020
• $82 for prenatal vitamins
• $46 for a telehealth call while in quarantine in Canada
• $13 for some throat lozenges

Considering we are expecting the baby in April, this year is projected to be an expensive healthcare year. I am sure other things will start hitting soon as well.

Passive Income & Government Tax Credits

I see a lot of other bloggers looking at how much of their “passive income” covers their regular living expenses. So, If I add up all our passive interest and dividend income from all sources including my non-liquid retirement accounts, I come up with about $18,398. This would include passive dividend income from my medical office building portfolio. It does not include capital gains or taxes.

$18,398 covers about 40% of the lifestyle above completely passively. For someone who considers himself a regular Joe Max, I find this pretty impressive.

$18,398 Passive Income / $46,207 Total Expenses = 39.8%

Additionally, our family qualified for both stimulus payments in 2020. In total, we received $3,600 from the federal government. That alone covered almost 8% of our 2020 spending.

At times, I have a hard time reconciling these government payments and think it’s odd that families like us are in receipt of these funds. For me, it is not as simple as “Oh you don’t like it? Just donate it to your favorite charity”. I suppose at the end of the day, it is a refundable tax credit that we qualify for.

Perhaps, I will touch more on that later.

Final Thoughts

Personal finance and budgeting are very much behavioral. It is one of the reasons I have a hard time providing personal finance advice to friends and family. By extension, I am weighing in on their spending behavior, and I don’t think that is any of my business.

But making the recommendation that someone should track their expenses? That seems like reasonable advice to me. I completed this early this year and it only took me a few hours. Ultimately, I still think it is worth the time.

Once again, the Max Out of Pocket crew lived it up on about $50,000. We do not have reason to spend anything less, but we could if we needed to. Our $100,000 opportunity fund could sustain this level of living for two years without lifting a finger. That’s a great feeling.

Arguably, most if not all of our $16,308 in “miscellaneous” expenses were completely discretionary. If we ever needed to tighten things up, we could. But I don’t expect that ever to be needed. If anything, I am looking to get more liberal with our spending as we move forward with life. We have already put the work in.

How much did you spend in 2020?

The post Max Out of Pocket’s 2020 Spending appeared first on Max Out of Pocket.

Either way, after being highly invested in stocks/equities through most of the longest bull market in history, I am building a new foundation. I am calling it “Max’s opportunity fund”, and it will live in our liquid taxable investment portfolio. It is part of an overall effort of cleaning up our personal finance house ahead of 2021.

So, what is it and why do we need it?

Building the Opportunity Fund

I picked the nice round number of $100,000. 

Now, I normally wouldn’t advocate for such a large, somewhat conservative investment. But they say if you expect to need your money within the next five years, the stock market isn’t always the best place for it. I have heard this advice from more than one personal finance guru, and I happen to agree with the thinking. Although the general long-term trajectory of the stock market is up, it can be a wild ride. Selling assets in a down market can play mind games on even the most stoic of investors.   

I think there is a good chance the Max Out of Pocket crew will need to access a sizable chunk of our liquid portfolio in the next five years. So, I have created a fund to make sure we have those assets handy when we need them. I almost got original and called it the “Let’s Do This!” fund but that just didn’t have the ring I was going for.

I started building this fund earlier in 2020 and recently completed the cornerstone of our liquid investment portfolio.

I sold this holding for a $22,000 long-term capital gain, all proceeds going into our opportunity fund. It is almost obnoxious I could clear $22,000 without lifting a finger. Okay, I guess I did lift a finger to click the mouse, twice.

To me, that’s a ton of money. But I am well aware this is small-time compared to people who have serious money. This $22,000 would cover almost half of our annual budget and I know seniors who live on a fraction of this every year. In fact, my own disabled sister lives on about $13,000/year from Social Security. I’m guessing that’s the going rate.

Not to be Confused with an Emergency Fund

The opportunity fund is not to be mistaken for the emergency fund. An emergency fund really can’t be accessed for any reason except for a true emergency. Scary things like layoffs, accidents, health scares, deaths in the family, or illness might be a reason to tap into an emergency fund. Our $51,436 emergency fund represents a full year of expenses and it sits safely in a short-term bond fund. I call it a fully funded year. Overkill? Yes. Opportunity cost? Yes. But it helps me sleep at night.

I moved our emergency fund from Vanguard’s money market to this short term bond fund. I couldn’t stomach $0.42 monthly returns on $50,000.

The opportunity fund, on the other hand, comes with built-in flexibility. Certain predetermined parameters allow us to access money from the fund. Although we keep it in conservative bond investments, we are willing to accept a little more risk with this fund as compared to our emergency fund. So instead of short-term bonds, we go with intermediate-bonds.

What can we use it for?

So, what can we use this money for? As you might expect, Max has drafted bylaws for that. These will be finalized by 1/1/2021.

This isn’t vacation money. It’s not fun money, either. We pay for that type of stuff through our normal budget and generally don’t need to plan for it. In fact, we lived it up in 2019 on $51,436 which included a trip to Ecuador (to hang out with other personal finance masterminds) and the Galápagos Islands, a new computer, US citizenship, and over $1,700 on our damn cats. We will come in under that in 2020 even after paying $7,000-$8,000 for Mrs. Max OOP to study abroad.

So if you set up an opportunity fund, it is a good idea to also set up some rules to make sure you do not accidentally spend down the fund in Las Vegas. I have gone ahead and laid out some “triggers” that will allow us to access this money in 2021.

• Buying a house
• Long-term rental in another country; “restart money”
• Starting a business
• Re-invest in the stock market in the event of a market correction of 10% or more
• Short term loan for retirement contributions or a car purchase

I think these are clear and easy to understand, but let’s expand a bit.

Buying a House

Buying a house allows for 100% depletion of the fund. It is the most likely scenario where we would tap into this little nest egg. Frankly, a potential home purchase has been my primary motivation for establishing the fund in the first place.

The Max Out of Pocket crew has been renting a modest place in the mountains for the last four years. We pay $12,000 per year in rent. Since we rent, we do not have any home equity. Unlike most of my peers, if we decide to buy a house in the future, we will not have a house to sell that will provide capital for the purchase. We recently went through that process when we sold our place in North Carlina to move to New England. 

Having $100,000 readily available for a house makes me feel better about the prospect of dipping back into the real estate market. Buying a house is stressful enough on its own without having to worry about what investments you are going to sell to fund the purchase. This fund will prevent me from the emotional roller coaster of potentially selling stock market investments in a down market to support the purchase. Without it, I could even see delaying a home purchase all together in a bear market. The opportunity fund positions us not to need to worry about any of that.

Max’s opportunity fund represents a 20% down payment on a $500,000 (USD) house in the United States and a $660,000 (CAD) house in Canada. It is unlikely we would ever drop that much on a house. I think $200,000 to $300,000 fits much better into our reasonable standard of living. That entry point would put us at close to a 50% down payment.

Re-start Money Abroad

Although we currently live in the United States, Mrs. Max OOP has ties to both Canada and Australia. She is a citizen of both countries and recently added a US citizenship to the shelf. Some people collect coins, she collects citizenships. With her US citizenship in the bag, we have a renewed sense of flexibility.

We have seriously considered moving to both places. It just so happens Mrs. Max has been living in Canada for more than 3 months. She will be back in a few weeks.

Australia would likely be a short term “experience” move for a year or two versus putting down real roots. Canada would be more of a long term move with an intent to settle down.

One problem with moving to Canada or Australia is my skillset does not seem to be as marketable in those two countries. Apparently, healthcare finance is a lot less complex when it is nationalized, and you don’t need to overpay people like me to manage the financial system.

I don’t think my salary would even come close to what I am making here in the United States. So, if we were ever to make a move like this, I would want it completely pre-funded for a few years. This fund would help shelter us from stock market volatility. It would give us time to establish ourselves without putting ourselves at risk with an unfavorable sequence of returns.

A move elsewhere in the United States would likely be fully funded by my future employer, so there would be no reason to tap into the opportunity fund.

Starting a Business

This one seems somewhat unlikely to happen within the next five years, but I suppose it is possible. Mrs. Max OOP has picked up a completely new skillset over the last few years. Opening a butcher shop would carry a lot of risks, and I do not have a good feel for the initial capital investment. It does seem like $100,000 would be a good starting point. I have lightly googled it and it appears to be in the ballpark.

We both like the idea of working for ourselves, but there is a lot to explore here. If there was a formal plan drafted to open a shop, there would probably be a full year of saving ahead of this project in addition to the opportunity fund.

Outside of that, I no longer have a ton of ambition to start my own business. I would rather leave that risk with a corporation and just enjoy the work.

Stock Market Investments

This one is a little gray and some will accuse me of trying to time the market and laugh me out of the room. They would probably be right. As I write this, the stock market is sitting at or close to an all-time high. The Shiller P/E ratio, an indicator I like to keep an eye on, is also double the average. I won’t get too much into the technicals, but the stock market is currently priced at 33 times the inflation-adjusted earnings from the last 10 years. There are plenty of good reasons for that, such as a favorable corporate tax rate and free money from the fed. I am sure there are others, and I am not an expert.

The market seems expensive, but we have been saying that for years now and nothing makes this year any different than last year.

I have no idea if the overall market will go up or down from here. But I do know if it goes down by 10% (meets the definition of market correction) or more, my opportunity fund’s “bylaws” allow me to make a large purchase of the total stock market index. Here are the details: The first purchase must be $10,000 or more, with $1,000 dollar cost averaging allowed thereafter. Only 50% of the fund can be used for this type of purchase. It must be paid back with future income as quickly as possible. We don’t allow purchases of individual stocks, only large sections of the entire stock market.

Short Term Loan

This is another one that can also get tricky if we don’t define it. There are only two reasons that would allow a short-term loan from the fund.

Mrs. Max OOP and I both currently drive aged-out Hondas. Mrs. Max OOP’s 2007 Civic seems solid, and she has been driving it since 2007. Her goal is 250,000 miles or more.

My 08′ Odyssey just passed 200,000 miles and is a little more questionable. I bought it from a colleague at work a little under market back in 2015. I have gotten hit with a few $500+ repairs over the years and I just put new breaks on it last week.

They recently passed inspection (hence the new rear breaks) and I suspect both will make it through 2021 considering almost all our transportation is within a few miles of the house. That said, buying a new vehicle has been in the back of my mind for over 6 months. I have been considering a mid-sized SUV. If we decide to purchase a new vehicle in 2021, our rules say that we can access up to $30,000 from the fund if financing options do not make sense. This will require payback as quickly as possible through regular income.

Secondly, I am allowing a lump sum withdrawal of up to $12,000 to fund our Roth IRA accounts in 2021 should we decide to do that all at once. Again, it will require payback a quickly as possible through regular income. 

Where do we keep the opportunity fund?

We are holding our opportunity fund at Vanguard in an investment-grade bond fund with intermediate-term maturities. Unlike stocks where we own part of a company that produces revenue and earnings, bonds are a debt owed to the bondholder. Max is essentially the bondholder. Kind of like my Series I Bonds, but the government owes me that debt.

Investment-grade bonds are considered a lower risk, low reward situation.

Vanguard Intermediate-Term Investment-Grade Fund Admiral Shares (VFIDX)

These are Admiral Shares, so you need at least $50,000 to access this fund. The expense ratio is only 0.10%. It does have a little brother that is a little more expensive but gets you the same thing for only a $3,000 investment.

The fund invests in corporate bonds, pooled consumer loans, and U.S. government bonds. You know, boring, but stable stuff. Intermediate-term bonds like these tend to have a higher yield than the money markets and short-term bonds. That said, the share price can fluctuate more as interest rates move. The average term of the bond in this particular fund is 5 – 10 years. The companies who issue the bonds have really solid credit quality and a high likelihood of having the ability to pay back the debt.

Look at these credit ratings:

In other words, not completely risk-free, but it should let me sleep at night.

Past Performance is Not Indicative of Future Results

Here is how $10,000 would have grown over the last 10 years.

There is certainly an opportunity cost to our opportunity fund. (Like what I did there?) If the overall stock market puts up another 30% gain in 2021, I will be leaving almost $30,000 on the table. But it is a price I am willing to pay to build some additional flexibility and stability to our personal finances. I have already missed out on over $5,000 in gains since I sold that $75,000 mentioned above. I don’t really care; we already have enough money.

$100,000 x 30% gain = $30,000

It’s kind of like staying at a lower stress job when you know you could make a higher salary somewhere else. My hypothetical yield as I write this is only 1.54%, suggesting we will only net about $1,500 on this over the next year.

$100,000 X 1.54% = $1,540

A Few Other Rules

This fund will generate about $100-$150 a month in interest which will be automatically reinvested into the fund.

Lastly, this fund will be reviewed no more than annually to make decisions on whether the balance should be increased, decreased, or moved into a more conservative fund. We do not want to be looking at this balance too often since that will defeat the purpose of simplifying my financial life.

Final Thoughts

Creating this foundation is part of a deliberate effort to simplify my personal finance life and open some capacity for other things. I am even formalizing an investor policy statement for 2021 and cleaning up my medical office building portfolio.

Building up enough assets to be able to carve a fund like this out of our portfolio took years of hard work and focus. Mrs. Max OOP is a part-time teacher with a very modest salary, and I just started making what I would call good (not great) money 3-4 years ago.

It is important to recognize that $100,000 will always be a shitload of money to me. It doesn’t take much to make me happy, and we could probably live off it for 3-4 years if we really had to.

Additionally, It would be remiss of me if I didn’t mention that this is part of a broader target allocation strategy, but we can cover that another time. I generally wouldn’t recommend putting such a large allocation like this into such a conservative investment, but our situation and needs are unique.

I like the opportunity fund concept. When you need access to capital, it takes stock market volatility out of the decision-making process. The last thing I want to worry about when pursuing an opportunity is the fact that I am selling depreciated stock market assets to fund the purchase. 

It may sound like Max is becoming soft or a bit too conservative, particularly considering I have not retired early and plan to continue working full time. Or worse, maybe I am trying to time the market. That is not necessarily the case. My risk tolerance is quite high for everything outside of our emergency fund and opportunity fund. If anything, having a solid foundation like this makes me even more confident in investing all future income in more aggressive stocks and equities. There is no more decision point to future investments; it’s automatic. All future investments go into stocks and equities. I know I can’t time the market.

An opportunity cost comes along with this fund. We get some protection from inflation, but that is about it. There is also a tax drag on the fund. These are all things I have thought through, and am willing to pay for.

Do you have an opportunity fund? What else am I missing? Healthcare is my thing, but I am starting to get the sense there are people reading this that really know their “personal finance”.

I’m listening.

This is not a recommendation to do anything like this with your own personal finances. This decision will most likely leave THOUSANDS of dollars on the table over the long term. I’m fine with that, we already have enough money.

The post Max’s $100,000 Opportunity Fund appeared first on Max Out of Pocket.

But there are also some basic things we should keep an eye on.

One of the metrics that got away from me over the years is how much of our net worth is easy to access. These days I call this our asset liquidity ratio.

Earlier this year, I started wondering if I put too much away for retirement in my 20s. I even mentioned it in a personal finance round-up I participated in back in December. Was my laser focus on maximizing tax advantage accounts to get to financial independence an error? Was I robbing young Max to pay the old and decrepit Max? What if I didn’t make it to my golden years?

Did I have balance?

Retirement Accounts

Retirement accounts are great. They can save us some serious money. From the 401(k) deferring taxes to the Roth IRA providing tax-free growth, there is no question they will accelerate our way to becoming financially independent.

The problem is they also lock your money up for years. Complicated rules are in place that aim to keep us from accessing our money before the traditional retirement age of about 60. There are plenty of workarounds and exceptions, but understanding those take time.

The bottom line is these accounts are not meant to be liquid in the near term. We usually need to jump through more than a few hoops to access the money before the traditional retirement age.

And let me tell you, 60 is a long way off.

Taxable Accounts

Taxable accounts, on the other hand, are extremely liquid. Checking and brokerage accounts grant us almost instant access to our money. The drawback? Interest, dividends, and capital gains on investments are all taxed the year the income is realized. In other words, there is a “tax drag” on this piece of our portfolio. A larger balance equates to a larger tax drag. I consider this just part of the cost of liquidity.

But outside of the tax drag, money in these accounts is generally easy to access.

Asset Liquidity Ratio

So how do we balance capitalizing on tax-advantaged accounts while also keeping liquidity in check? Well, one place to start is knowing how much of our net worth is in liquid accounts.

Liquid Net Worth / Total Net Worth = Asset Liquidity Ratio

I’m sure this doesn’t meet the technical accounting definition, and I don’t really care. That’s another good thing about having a hobby in personal finance, you can make up ratios out of thin air. Even if they are probably technically percentages.

For the Max Out of Pocket crew, we have been running an average of 28.68% in liquid net worth since early 2018. As of August 2020, we are up to 31.16%.

In other words, 31.16% of our assets are easy to access. This includes things like our taxable brokerage accounts, checking accounts, Fidelity cash management account, government I-bonds, and even the cash in our pockets.

It does not include things like our 403(b), Traditional IRA, Roth IRA, H.S.A., or state pensions. I also do not include other non-liquid assets such as our cars or a house (if we owned one). The majority of our net worth currently sits in tax-deferred IRAs.

That Seems Low, Max

There are two sides to this.

The fact that we only have easy access to 30% of our assets does seem low to me. I was noticing the folks over at TicTocLife are at a much healthier 47% in their checking and brokerage. I think that is a good spot to be considering their total assets.

Ultimately, it is a percentage I would like to increase a bit. It is one of the reasons I decided not to front-load my 403(b) account in 2020. I needed some time to think through this. Now I am not even planning on maxing it out.

On the flip side, this shows that despite not having an explosive income out of college, I have been doing a great job prioritizing retirement savings. Even when I had a much lower income, I always made it a priority to dump truckloads of money into my retirement accounts. That money grew exponentially over the last decade. In fact, with our reasonable standard of living, we probably do not need to save another dime for retirement because we still have a super long time horizon for these assets to grow through the stock market.

Did Max Overutilize Retirement Accounts?

I do not think I necessarily made a mistake here. Our tax-deferred accounts have been able to take advantage of the roaring stock market over the last 12 years. Additionally, our federal effective tax rate was extremely low for most of those years. For several of them, I was able to capitalize on a 0% capital gain rate in my taxable accounts by deflating our adjusted gross income with tax-deferred accounts. One year shortly after Mrs. Max OOP came on the scene, I got it so low I even accessed the saver’s tax credit. One of the few benefits of her meager teacher salary.

Through all of that, never once did I feel I was depriving ourselves for the sake of saving. I certainly kept an eye on things, but we definitely weren’t slumming it. We regularly traveled internationally and lived in nice places.

That said, there is a chance the future me might wish we had easier access to our assets. I can think of two things that might trigger that reaction: buying a house or starting a business.

Although I enjoy renting, we will likely eventually buy a house again. Depending on the market, we could definitely absorb a purchase, but our liquidity ratio would suffer. Unfortunately, I don’t think we could pay cash for a house in some of the markets we are looking at. We could easily put 50% or more down, though, which isn’t a bad place to be.

Opening a business is a wildcard. Mrs. Max OOP is currently in training out in Alberta, and we have no idea what the next steps to that project are, but it could turn into a significant investment. I suppose a small business loan would always be an option.

Early Withdrawal Options

All that said, we do have options for early withdrawal, and I understand them. The Roth IRA gives us some liquidity after contributions sit for five years and our 401(k) offers loan options. There are also those fancy Roth IRA conversion ladders that might make sense in an early retirement scenario.

But for the average Joe-Max learning about personal finance, we should put early withdrawal strategy aside. A liquidity ratio is a good metric to keep in check and can make sure you are balancing the goals of both your future self and your current self.

Do I sound like Dr. Emmet Brown yet? 

Fixing This Ratio

Ultimately, so far in 2020 I have been attempting to correct our liquidity ratio. There are challenges, though.

One thing I am finding is the money in our retirement accounts is working harder than we can. Capital gains and dividend distributions keep those retirement balances growing and it is a hard thing to offset with regular income. While that’s certainly not a bad thing, it could make correcting our liquidity ratio a challenge.

Most of our liquid assets are invested in the stock market. But I also hold most of our “cash equivalent” allocation in our liquid accounts as well. So we do not benefit from market returns on that money. This comes to $51,436 (representing a full year of expenses) and is a number I am considering increasing, which will further slow us down. This money barely keeps up with inflation.

I am also still making small contributions to my Roth 403(b) to capture my employer’s contribution match. This doesn’t help the ratio.

Final Thoughts

I am always looking at financial ratios of health systems. Cost to charge ratios, net to gross revenue ratios, and cash on hand can give me a good pulse on the organization. The same goes for personal finance.

But this is just one metric. There are plenty of other indicators to check when looking at the big picture. But I think it is a good one to monitor early on in personal finance to make sure you are not locking too much up in retirement accounts.

Overall, I don’t think I made a mistake here. Theoretically, assuming we stay the course, our net worth will grow to a point where this doesn’t even matter. Our reasonable standard of living just does not take much to sustain. When you think about it, 30% of a lot of money, is still a lot of money. The ratio is probably something we only need to look at early on in personal finance.

For us, we still need to keep an eye on this for a few more years.

Frankly, 2020 will likely be the first year in a long time that I don’t max out my retirement account. With Mrs. Max OOP on sabbatical, we will be on the cusp of a lower tax bracket, and I want to pay the tax now and take advantage of it. Additionally, early retirement is seeming more and more unlikely for me these days. It turns out I like working. and the odds are I will fill up my $572,570 standard deduction bucket anyway.

As a result, we have been able to move our ratio from 28.83% to 31.16% over the last 8 months. I expect that number to continue to improve, especially if the overall stock market dips again.

What is your asset liquidity ratio? I’m almost sure it is better than ours.

The post Our Asset Liquidity Ratio appeared first on Max Out of Pocket.

As you already know, Max likes real-life experiments. So, back in 2019, I set up a little experiment to add a few more paper bonds to my government savings bond portfolio. The net result of the experiment was $1,000 in paper I bonds delivered to my PO Box.

How Does the I Bond Work?

Series I bonds are a government savings bond that earns interest based on combining a fixed rate and an inflation rate. Unfortunately, at the time of writing this, the fixed portion of the bond rate has been reduced back down to 0.0% thanks to the pandemic. The combined composite inflation rate puts the current interest rate at 1.06%. Here is the calculation example directly from the treasury.

For comparison purposes, the $51,436 in cash I am holding in my Vanguard Prime Money Market Fund (VMMXX) is only yielding about 0.39% at the time of writing this.

We are limited to buying $10,000 in I bonds electronically each year. But we can buy an additional $5,000 in paper I bonds each calendar year through our tax return. As I mentioned above, this is the only way to get the paper version of the bond.

I bonds could be a good investment vehicle for the conservative investor or someone who wants to build a safety net for the future. They do require some light planning and understanding of how they work. So, there are few rules surrounding I bonds we should understand. I went ahead and put some of the important ones below that I found interesting. As always, make sure you do your own research and read the fine print.

Interest 

Interest rates are pretty marginal at this point. Let’s face it, locking in at a 0.00% fixed rate is pretty low compared to historical standards. The combined rate is 1.06% through October 2020 when you add in the inflation factor. There is also deflationary protection built into these bonds as outlined below.

There are a few unique things to note on how the interest rate is handled:

• I bonds have an annual interest rate derived from a fixed rate and a semiannual inflation rate derived from CPI-U.
• The fixed-rate remains the same throughout the life of the bond.
• The current rate is 1.06% for bonds issued May 2020 – October 2020.
• Interest-earning period: 30 years or until you cash them, whichever comes first.
• The combined rate will never be less than zero. However, the combined rate can be lower than the fixed rate. If the inflation rate is negative (because we have deflation, not inflation), it can offset some of the fixed rate.

Term

The term of the bond also has some things to consider:

• Minimum term of ownership: 1 year.
• Before 5 years, forfeit interest from the previous 3 months.
• After 5 years, no penalty.
• The interest rate accrues until the bond reaches 30 years (or you cash it).

Taxes

And last, but certainly not least, a few interesting notes on taxes:

• Tax reporting of interest can be deferred until redemption, final maturity, or other taxable disposition.
• Interest earnings are subject to Federal income tax.
• Savings bonds are exempt from taxation by any State or political subdivision of a State, except for estate or inheritance taxes.
• Interest earnings may be excluded from Federal income tax when used to finance education (see education tax exclusions).

Why Paper I Bonds?

As for me, I just wanted paper bonds because I have faith they (and the Unites States Government) will hold their value over time. They also have some flexibility on the tax side of things. I also happen to think they look pretty cool.

In 2019 when I arranged this purchase, the stock market had been on a 10-year run so I figured building in some conservative safeguards never hurts. I was already planning on filling up my $10,000 electronic limit in 2019, so this gave me the ability to go beyond that limit.

Then there’s this – someday I may need to teach interest rate concepts to my children, and they will definitely need visual aids.

I actually remember saving up $37.50 when I was a kid to purchase a $75.00 series E bond. When I got the physical bond, it showed $75.00. I asked my Mom and Dad almost every day how much it was worth until I was told (sternly) to stop asking. It was put away in a plastic holder next to my X-Men cards for safekeeping. I still have it and I believe it is netting 4% per year until 2026.

Getting the I Bonds

When I bought my bonds back in 2019, I had to use part of my CY 2018 tax refund. The fixed-rate on the bond at the time was set at 0.50%. Before that, it hadn’t been that high since November of 2008.

So I purposely overpaid taxes in CY18 to make sure I could score some paper bonds from my Uncle Sam come 2019. I already hear you cringing:

“Max, did you really give an interest-free loan to the federal government just to get a paper bond at a fixed 0.50% interest rate plus inflation?”

Yes, I did.

So how did I get them?  I basically answered the question as “Yes” when Turbo Tax asked if I wanted I bonds as part of my tax refund. I requested $1,000 worth. Behind the scenes, IRS Form 8888 was generated and requested the bonds. 

Since these bonds were issued in March 2019, the inflation rate adjustment will re-set to 0.0% in September and start paying a 1.56% composite rate.

Leave it to the Government

Max was surprised to find I was sent 8 separate I bonds all mailed in 8 separate envelopes with 8 separate postage fees. Okay, I suppose I was actually a little pumped to have a stack of government I bonds to show all my friends. If I would have read the fine print, it actually spells this out very clearly on the Treasury Direct website.

If you buy more than $250 of savings bonds, we will use $50 denominations to fill the first $250 and the fewest possible number of additional bonds for the remainder. For example, if you request $1,000 in paper I bonds, you will receive six $50 bonds, one $200 bond, and one $500 bond.

Treasury Direct Fine Print

I wonder who thought this one up?

Final Thoughts On I Bonds

Paper I bonds are a good way to tap into an extra $5,000 in inflation-protected bonds annually. In 2019, I purchased $10,000 in electronic I bonds and $1,000 in paper series I bonds. Unfortunately, the paper bonds are not FIREproof – no pun intended. Buy a safe.

Overall, I would say the process is a bit clunky and certainly not for a beginner in personal finance. You have to remember, Max considers this stuff a hobby so I am mostly just doing it to figure out how things work.

It also requires a short term loan to the government while you wait for the tax refund. Additionally, the Treasury Direct website could probably be simplified. I did not go this route in 2020 with my 2019 tax return, but I have bought several more electronically.

We will also eventually need to register these paper bonds with the Treasury Direct website to make sure that they are all accounted for. Until then, they will sit in my fireproof safe.

Do you own any I bonds?

This is not a recommendation to buy I bonds and only reflects my experiences.

The post The Name Is Bond, Series I Bond appeared first on Max Out of Pocket.